What Type of Businesses Often Use the Accrual Accounting Method?

Accrual accounting records revenues and expenses when they are earned or incurred rather than when cash changes hands. This approach provides a more accurate financial picture, making it essential for businesses with complex transactions or regulatory requirements.

Many organizations adopt accrual accounting due to industry standards, legal obligations, or the need for detailed financial reporting. Understanding which businesses use this method clarifies its advantages and why it is preferred in certain situations.

Publicly Traded Entities

Publicly traded companies must use accrual accounting under U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). The Securities and Exchange Commission (SEC) requires this method for all listed companies to ensure financial statements provide a complete view of financial health. Accrual accounting allows investors to assess earnings trends, liabilities, and future cash flows with greater accuracy, which is essential for informed investment decisions.

Regulatory compliance is a key driver. The Sarbanes-Oxley Act (SOX) of 2002 introduced strict financial reporting requirements, including Section 404, which mandates internal controls over financial reporting. Accrual accounting supports these controls by recognizing revenues and expenses in the correct periods, reducing the risk of financial misstatements. Additionally, the Financial Accounting Standards Board (FASB) issues Accounting Standards Updates (ASUs) that refine revenue recognition and lease accounting, both of which rely on accrual principles.

Beyond compliance, accrual accounting enhances financial analysis by offering a clearer picture of profitability and operational efficiency. Metrics such as earnings before interest, taxes, depreciation, and amortization (EBITDA) and return on assets (ROA) depend on accurate revenue and expense recognition. Investors and analysts rely on these figures to compare companies across industries, making accrual-based financials essential for market transparency.

Companies Maintaining Inventory

Businesses that manage inventory use accrual accounting to align revenue recognition with the cost of goods sold (COGS), ensuring financial statements accurately reflect profitability. Retailers, wholesalers, and manufacturers track inventory purchases as assets until the goods are sold, at which point COGS is recorded as an expense. This approach prevents mismatches between revenue and expenses that could distort financial performance under a cash-based method.

Tax regulations reinforce the need for accrual accounting in inventory-based businesses. The Internal Revenue Service (IRS) requires companies with average annual gross receipts exceeding $29 million (as of 2024) to use accrual accounting under Section 448 of the Internal Revenue Code. Additionally, businesses that produce, purchase, or sell merchandise must account for inventory under Section 471, which mandates capitalizing inventory costs until the related revenue is recognized. These rules prevent businesses from manipulating taxable income by deferring expenses.

Inventory valuation methods such as First-In, First-Out (FIFO), Last-In, First-Out (LIFO), and weighted average cost depend on accrual accounting principles. FIFO assumes the oldest inventory is sold first, which can increase taxable income in inflationary periods. LIFO, permitted under U.S. GAAP but not IFRS, allows companies to match recent higher costs with current revenue, reducing taxable income. The choice of valuation method significantly impacts financial ratios like gross margin and inventory turnover, influencing decisions on pricing, procurement, and tax planning.

Service Firms With Extended Billing Cycles

Businesses providing services over an extended period use accrual accounting to match revenue with the period in which it is earned. Law firms, marketing agencies, consulting firms, and architectural practices often engage in long-term projects where payments are received in stages or after project completion. Recognizing revenue only when cash is received would misrepresent financial health by ignoring work already performed but not yet billed.

Accounting standards require service firms to follow revenue recognition principles that reflect the transfer of services rather than cash flow timing. The Financial Accounting Standards Board (FASB) issued ASC 606, which outlines a five-step model for recognizing revenue from contracts with customers. For firms with extended billing cycles, this means identifying performance obligations, determining transaction prices, and recognizing revenue as obligations are satisfied. A consulting firm engaged in a year-long project, for example, may allocate revenue monthly based on project milestones rather than waiting for final payment.

Accrual accounting also ensures expenses incurred during service delivery are recorded in the same period as the corresponding revenue. Professional liability insurance, subcontractor fees, and employee salaries must be accounted for as they arise, even if the client has not yet paid. Failing to do so could inflate profitability in one period and understate it in another, making financial statements unreliable for decision-making. This is particularly relevant for firms operating on retainers, where clients prepay for future services, requiring deferred revenue liabilities to be recorded until the work is performed.

Partnerships With Significant Revenue

Large partnerships, such as law firms, medical practices, private equity firms, and hedge funds, use accrual accounting to provide a more accurate representation of financial performance. Given the complexity of revenue-sharing agreements and the timing of cash distributions among partners, tracking income and expenses based on when they are earned ensures financial statements reflect economic reality rather than short-term cash fluctuations.

Tax compliance is a major factor influencing the accounting method for high-revenue partnerships. Under the Tax Cuts and Jobs Act (TCJA), partnerships with average annual gross receipts exceeding $29 million (as of 2024) are generally required to use accrual accounting. The IRS mandates this to prevent deferring tax liabilities by delaying income recognition. Additionally, partnerships must adhere to Section 704(b) of the Internal Revenue Code, which governs how income, deductions, and credits are allocated among partners based on their economic arrangement rather than cash transactions.

In industries like private equity and hedge funds, accrual accounting helps track carried interest and unrealized gains or losses on investments. Since these firms generate income from asset appreciation and performance fees, recognizing revenue based on fair value adjustments ensures investors receive transparent reporting. Proper accrual accounting also aligns with GAAP requirements for fair value measurement, particularly under ASC 820, which establishes guidelines for valuing assets and liabilities using market-based inputs.

Nonprofit Organizations With Grant Funding

Nonprofit organizations that receive grant funding rely on accrual accounting to properly track revenue recognition and expense allocation. Since many grants come with restrictions on how and when funds can be used, recognizing revenue only when cash is received would not accurately reflect financial obligations or available resources. Instead, nonprofits must record grant income when awarded and recognize expenses as incurred, ensuring compliance with donor-imposed restrictions and financial reporting standards.

Government and private grants frequently require nonprofits to follow specific accounting guidelines, such as those outlined in the Financial Accounting Standards Board (FASB) ASC 958. This standard differentiates between conditional and unconditional grants, requiring organizations to recognize revenue only when conditions—such as performance milestones or matching fund requirements—are met. For example, if a nonprofit receives a $500,000 grant contingent on hiring staff for a new program, the funds cannot be recognized as revenue until the hiring occurs. This prevents overstating available resources and ensures financial statements accurately reflect the organization’s ability to fulfill its mission.

Accrual accounting also plays a role in tracking multi-year pledges and donor-restricted contributions. If a foundation commits to donating $1 million over five years, the nonprofit records the full pledge as a receivable and recognizes revenue as conditions are met. This approach aligns with GAAP and ensures stakeholders, including board members and regulators, have a clear picture of financial sustainability. Additionally, nonprofits subject to the Uniform Guidance for federal grants must maintain detailed records of expenditures, requiring accrual-based tracking to demonstrate compliance with allowable cost principles and prevent misallocation of funds.