Accounting basics: What is accrual accounting?

The cash method provides an immediate recognition of revenue and expenses, while the accrual method focuses on anticipated revenue and expenses. The primary goal of GAAP is to have accurate and is debit positive or negative consistent rules for financial reporting. Whenever a business sells an item, even on credit, the transaction is recorded immediately, regardless of whether or not payment is made at that time.

The general concept of accrual accounting is that accounting journal entries are made when a good or service is provided rather than when payment is made or received. According to this principle, revenue should be acknowledged once earned, independent of when payment is received. The matching principle is an accounting concept that states expenses tied to revenue should be recorded during the accounting period they occur.

What Is the Difference Between Cash and Accrual Accounting?

For example, imagine a dental office buys a year-long magazine subscription for $144 ($12 per month) so patients have something to read while they wait for appointments. At the time of the payment, the dental office sets up a prepaid expense account for $144 to show it has not yet received the goods, but it has already paid the cash. When a company receives cash before a good has been delivered or a service has been provided, it creates an account called deferred revenue, also referred to as unearned revenue.

• Accrual accounts include, among many others, accounts payable, accounts receivable, accrued tax liabilities, and accrued interest earned or payable.
• This has the effect of increasing the company's revenue and accounts receivable on its financial statements.
• Under the cash basis accounting method, a company accounts for revenue only when it receives payment for the products or service it provided a customer.
• When the goods are delivered to the customer, the payment is transferred from the liability account to the revenue account.
• Using the accrual accounting method, the landlord would set up an accrued revenue receivable account (an asset) for the $2,500 to show that they have provided services but haven’t yet received payment.

The effect of this journal entry would be to increase the utility company's expenses on the income statement, and to increase its accounts payable on the balance sheet. In accrual-based accounting, revenue is recognized when it is earned, regardless of when the payment is received. Similarly, expenses are recorded when they are incurred, regardless of when they are paid. For example, if a company incurs expenses in December for a service that will be received in January, the expenses would be recorded in December, when they were incurred. Taxpayers are typically required by the appropriate taxation authority to consistently use the method of accounting that accurately captures the entity’s true income. Consistency is essential since the swapping of accounting methods can potentially create loopholes that a company can use to manipulate its revenue and reduce tax burdens.

The Accrual Method of Accounting

By accurately identifying revenues and expenses, the company can ensure that its financial statements represent its financial position. Accrual accounting is one of the two most prominent accounting methods (the other being cash basis accounting). The accrual accounting method gives better insight into a company’s business operations from a financial perspective. It looks at revenue and expenses in tandem at the times that they are generated. An accrual is a record of revenue or expenses that have been earned or incurred but have not yet been recorded in the company's financial statements.

What are accruals?

In general, cash accounting is allowed for sole proprietorships and small businesses, whereas large businesses will typically use accrual accounting when preparing its tax returns. For example, a company should record an expense for estimated bad debts that have not yet been incurred. By doing so, all expenses related to a revenue transaction are recorded at the same time as the revenue, which results in an income statement that fully reflects the results of operations. Similarly, the estimated amounts of product returns, sales allowances, and obsolete inventory may be recorded. These estimates may not be entirely correct, and so can lead to materially inaccurate financial statements. Consequently, a considerable amount of care must be used when estimating accrued expenses.

How accrual accounting works

If you don't keep a close eye on both your accrual-based books and your actual cash flow, you can end up spending money you don't have—which can land your business in the red in no time flat. Plus, the IRS (Internal Revenue Service) requires that businesses making over $5 million use the accrual method. If your business starts out making under $5 million but eventually grows to exceed that mark (hooray!), you'll have to switch accounting methods, which is, trust us, an absolute mess. Well, with accrual-basis accounting, you'd record the full amount of the financial transaction as soon as you finish the project and send the invoice; in this scenario, the answer is January. The key advantage of the cash method is its simplicity—it only accounts for cash paid or received.

Impact of Accrual Accounting

In the accrual method of accounting, businesses will report income in the year it is earned, while expenses will also be recorded in the year they were incurred. The purpose of accruals is to ensure that businesses match their income and expenses accurately within an accounting year. However, if an inventory is necessary to account for your income or your company’s income is over $25 million, the IRS will require you to use the accrual method. The main difference between accrual and cash accounting is when transactions are recorded. Accrual accounting recognizes income and expenses as soon as the transactions occur, whereas cash accounting does not recognize these transactions until money changes hands. Accrual accounting is an accounting method that recognizes revenue in the period in which it’s earned and realizable, but not necessarily when the cash is actually received.

Recording Accruals on the Income Statement and Balance Sheet

An employer may satisfy its obligations through a “combined” sick time/PTO policy, provided the policy complies with the minimum requirements of the paid sick leave law. Under an “accrual” policy, employees must earn at least one hour of paid sick leave for each 30 hours of work (i.e., a ratio of 1 to 30). Third, you subtract the accrued, or accumulated, expenses from your accrued income. That number is called your net profit or loss, depending on whether you got a positive or negative result.

Additionally, cash basis and accrual differ in the way and time transactions are entered. For instance, a company that charges an hourly fee for its services might bill its customers at the end of every month. Accrual is standard accounting practice that would let the company put the revenue from the hours it works on its books as they occur rather than having to wait for when the client pays.