What Is the Accrual Basis of Accounting?

Businesses use structured methods to monitor their financial health and operational outcomes. These methods involve systematically recording how and when economic events impact a company’s financial standing. A core aspect of this process is determining when income is recognized and when expenses are incurred. Different approaches exist, each influencing the financial picture a business presents.

Understanding Accrual Basis Accounting

Accrual basis accounting records financial transactions when they occur, regardless of when cash changes hands. Revenue is recognized when earned, typically when goods or services are delivered, even if payment is not yet received. For instance, if a consulting firm completes a project in July but receives payment in August, the revenue is recorded in July. This method matches income to the period when work was performed.

Expenses are recognized when incurred, meaning when a liability is created or an asset is consumed, regardless of when cash payment is made. For example, if an advertising agency receives an invoice for July’s rent in July, the expense is recorded in July, even if payment is due in August. This approach provides a more accurate depiction of a company’s financial performance by aligning revenues with related expenses within the same reporting period.

Accrual Basis Compared to Cash Basis

The primary distinction between accrual and cash basis accounting is the timing of revenue and expense recognition. Cash basis accounting records revenues only when cash is received and expenses only when cash is paid. For example, a small landscaping business on a cash basis records revenue when a customer pays, and costs when a supplier’s bill is paid. This method provides a straightforward view of cash flow, suitable for very small businesses or individual taxpayers.

Accrual accounting focuses on the economic event, recording transactions as they happen, independent of cash movement. If the landscaping business uses accrual accounting, it recognizes revenue when the service is completed, even if the client has 30 days to pay. Similarly, the expense for supplies is recognized when used, not when the bill is paid. This timing difference means accrual accounting provides a more comprehensive representation of a company’s financial health, including accounts receivable and accounts payable. While cash accounting shows immediate cash positions, accrual accounting offers a clearer picture of profitability by matching revenues to expenses.

Underlying Principles of Accrual Accounting

Accrual accounting is guided by principles that ensure financial statements accurately reflect a business’s economic activities. The Revenue Recognition Principle dictates that revenue is recorded when earned and realized, regardless of when cash is collected. Revenue is earned when the company delivers goods or services and expects payment. For instance, a software company records revenue when its subscription service is available to a customer, not necessarily when the fee is received upfront. This principle ties financial performance to the completion of obligations.

The Expense Matching Principle requires expenses to be recognized in the same accounting period as the revenues they helped generate. This ensures costs associated with earning revenue are reported in the same period, providing a clear picture of net income. For example, if a retailer sells a product in December, the cost of that product is also recorded as an expense in December, even if inventory was acquired earlier. These principles collectively provide a more complete and reliable assessment of a company’s profitability and financial position over a specific period.

Common Accrual Adjustments

Accrual accounting requires specific adjustments at the end of an accounting period to ensure revenues and expenses are recognized in the correct timeframe.

Accrued revenues are revenues earned but for which cash has not yet been received. For example, a law firm completing services in December but billing in January records accrued revenue in December.
Accrued expenses are expenses incurred but not yet paid. Employee salaries earned in December but paid in January are recorded as an accrued expense in December.
Unearned revenues occur when cash is received but revenue has not yet been earned. If a magazine publisher receives advance payment for a subscription, it’s initially unearned revenue. As magazines are delivered, the revenue is recognized.
Prepaid expenses are cash payments for expenses not yet incurred, like paying six months of office insurance in advance. This creates an asset, which is then expensed over the coverage period.

Mandatory Use of Accrual Accounting

For many businesses, accrual accounting is a requirement. Generally Accepted Accounting Principles (GAAP) in the United States and International Financial Reporting Standards (IFRS) globally mandate its use for most entities. Publicly traded companies, for instance, are required by regulatory bodies like the Securities and Exchange Commission (SEC) to prepare financial statements using accrual methods. This ensures consistency and comparability for investors and other stakeholders.

The Internal Revenue Service (IRS) also requires businesses with average annual gross receipts exceeding a certain threshold to use the accrual method for tax purposes. Accrual accounting provides a complete picture of financial performance and position, making it the standard for transparent financial reporting to investors, creditors, and other external parties.