What Is an Accrual in Accounting and Why Does It Matter?

An accrual in accounting is a fundamental concept that recognizes economic events when they occur, regardless of when cash is exchanged. Its purpose is to record revenues when they are earned and expenses when they are incurred. Accruals ensure that financial transactions are captured in the period they happen, providing a more accurate and complete representation of a company’s financial performance.

Accrual Basis Versus Cash Basis Accounting

Accounting methods differentiate between the accrual basis and the cash basis. Accrual accounting records revenues when earned and expenses when incurred, irrespective of the timing of cash receipts or payments. For instance, a sale on credit is recorded as revenue when goods or services are delivered, even if payment is received later. An expense is recorded when the benefit is received, such as using electricity, even if the utility bill is paid in a subsequent period.

In contrast, cash basis accounting recognizes revenues only when cash is received and expenses only when cash is paid out. For example, revenue from a sale on credit is not recorded until the customer’s payment is in hand. While simpler for small businesses, cash basis accounting does not provide a comprehensive view of a company’s financial standing. Accrual accounting is preferred for most businesses, especially larger ones, as it offers a more accurate reflection of financial performance and position over a specific period.

It better aligns economic activity with reported results, aiding in decision-making for management and investors. Many larger U.S. businesses with average revenues exceeding $25 million over three years are required to use accrual accounting for tax purposes.

Common Accrual Types and Examples

Accruals are broadly categorized into accrued revenues and accrued expenses, representing transactions where economic activity has occurred but cash has not yet changed hands.

Accrued revenues, also known as accrued income or accrued assets, represent revenues a company has earned by providing goods or services but has not yet received payment. These are recognized as assets because they represent a future economic benefit or claim to cash. For instance, if a consulting firm completes a project in December but will not receive payment until January, the revenue is accrued in December. Another example is interest earned on an investment that will be paid out later.

Accrued expenses, also referred to as accrued liabilities, are expenses a business has incurred but has not yet paid. These are recognized as liabilities because they represent an obligation to pay cash in the future. A common example is employee salaries earned in December but paid in January; the wages are accrued as an expense in December. Similarly, utility costs for services used in December but paid in January would be recorded as an accrued expense in December.

How Accruals Shape Financial Statements

Accruals ensure the accuracy and completeness of a company’s financial statements, particularly the income statement and balance sheet.

On the income statement, accruals ensure that revenues are matched with the expenses incurred to generate them in the correct accounting period. This adherence to the matching principle means that if a company makes a sale, all direct costs associated with that sale, such as the cost of goods sold or sales commissions, are recognized in the same month, even if the cash for those expenses is paid later. This provides a more accurate representation of the company’s profitability for that specific period.

On the balance sheet, accrued revenues are reported as current assets, often as “Accrued Revenue” or included within “Accounts Receivable,” because they represent amounts owed to the company for services rendered or goods delivered. Conversely, accrued expenses are presented as current liabilities, frequently labeled as “Accrued Expenses Payable” or “Accrued Liabilities,” indicating obligations for goods or services received but not yet paid. This reporting provides a complete picture of the company’s financial position, reflecting both what is owed to the business and what the business owes to others.