What Is an Accrual Basis of Accounting?

Accrual basis accounting is a method of financial record-keeping that focuses on when revenues are earned and expenses are incurred, rather than solely on the movement of cash. This approach helps match income with the costs of generating it, providing a clearer picture of financial performance. It forms the foundation for financial statements.

Understanding the Core Concept

Accrual basis accounting operates on two principles: revenue recognition and expense matching. Revenue recognition dictates that revenue is recorded when earned, meaning when goods or services are delivered or performed, regardless of when cash is received. For example, a consulting firm performing a service in June recognizes revenue in June, even if paid in July. This ties income to the period of economic activity.

Expense matching requires expenses to be recorded in the same period as the revenues they helped generate. Costs are recognized when incurred, not necessarily when cash is paid. For example, if a business sells a product in December, its production cost is recognized in December, even if the supplier is paid in January. This process provides a more accurate representation of profitability by aligning efforts with results.

Key Elements of Accrual Accounting

Accrual accounting involves specific entries for transactions where cash and economic activity do not coincide. These include:

Accrued Revenues: Income earned but not yet received. For example, a utility company providing electricity before billing records accrued revenue. These amounts are recorded as accounts receivable, which are assets on the balance sheet.
Deferred Revenues (Unearned Revenues): Cash received, but revenue not yet earned. This occurs when a customer pays in advance for future goods or services, like an upfront insurance premium. This payment is recognized as a liability because the company owes a future service. As the service is delivered, the liability is reduced, and the amount is recognized as earned revenue.
Accrued Expenses: Costs incurred but not yet paid. Examples include employee wages earned but not disbursed, or utility services consumed but not billed. These expenses are recognized in the period they occur, reflecting the obligation to pay, and are recorded as liabilities like accounts payable.
Prepaid Expenses: Cash paid for an expense not yet incurred or used. These are advance payments for goods or services to be consumed in a future period, such as a year of office rent. Initially, prepaid expenses are recorded as assets. As the benefit is received, a portion of the prepaid asset moves to an expense account, reflecting its consumption.

How Accrual Basis Differs from Cash Basis

The distinction between accrual and cash basis accounting lies in the timing of revenue and expense recognition. Under the cash basis, transactions are recorded only when cash changes hands. Revenue is recognized when cash is received, and expenses when cash is paid. This method is straightforward and common for very small businesses or individuals.

In contrast, accrual accounting records revenues when earned and expenses when incurred, irrespective of cash exchange. For instance, if a business completes a service in December but receives payment in January, accrual records revenue in December. A cash basis business records it in January. Similarly, if a business incurs a utility expense in June but pays in July, accrual recognizes the expense in June, while cash basis records it in July.

These differences impact a company’s reported financial performance. Accrual accounting provides a more accurate picture of profitability by matching revenues with expenses. While the cash method simplifies bookkeeping and shows immediate cash availability, it may not reflect a business’s full economic reality, especially with credit sales or deferred payments.

Who Uses Accrual Basis

Accrual basis accounting is widely adopted and often mandated for larger businesses. Generally Accepted Accounting Principles (GAAP), the common accounting standards in the United States, require the accrual method for financial reporting. Public companies must comply with GAAP to provide transparent financial statements.

The Internal Revenue Service (IRS) also has requirements for the accrual method. Businesses with inventory generally must use the accrual method for related purchases and sales. Most C corporations, partnerships with a C corporation partner, and tax shelters must use an overall accrual method. Small business taxpayers with average annual gross receipts not exceeding a certain threshold may use the cash method.

Beyond regulatory compliance, accrual accounting offers benefits for financial analysis and long-term planning. It provides a detailed understanding of a company’s financial health, including accounts receivable (money owed) and accounts payable (money owed by the business). This view supports informed decision-making and management of future obligations.