What Is Accrual Accounting?

What Is Accrual Accounting?

Let me explain accrual accounting directly to you: it's a financial accounting method where you record revenue before you actually receive payment for goods or services sold, and you record expenses as they are incurred.

In simple terms, you enter the revenue earned and expenses incurred into your company's journal no matter when the money actually changes hands. I often compare accrual accounting to cash basis accounting, which only records revenue when the goods and services are paid for.

How Accrual Accounting Works

The core idea here is that you make accounting journal entries when a good or service is provided, not when payment is made or received. You also enter debts and payments due.

This approach combines current and future cash inflows or outflows to give you a more accurate picture of your company's current and long-term finances. Accrual accounting sticks to the matching principle, meaning revenues and expenses get recorded in the same period.

It's encouraged by International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP), so most companies use it as standard practice, except for very small businesses and individuals.

Qualifying for Accrual Accounting

If your company has average gross receipts over $25 million in the previous three years, you are required to use the accrual method. If you don't meet that revenue threshold, you can choose between cash basis or accrual.

That said, accrual accounting is always mandatory for companies that carry inventory or make sales on credit, no matter the size or revenue.

Benefits of Accrual Accounting

You get a more accurate picture of your company's current condition with accrual, though it's more complex and expensive to implement.

This method developed from the growing complexity of business transactions and the need for precise financial information. When you sell on credit or handle long-term projects, those affect your financial condition right away, so they should show up in your statements during the same period.

With accrual, you receive immediate feedback on expected cash inflows and outflows, which helps you manage resources and plan ahead. Keep in mind, accrual gives a truer financial position, but many small businesses stick with cash accounting because it's simpler.

Accrual Accounting vs. Cash Accounting

Accrual differs from cash accounting, which only recognizes transactions when cash is exchanged. The timing and entry of transactions vary between them.

In cash accounting, you record transactions when payments happen. For instance, if a consulting company provides a $5,000 service on October 30 and the client pays on November 25, you record the $5,000 as owed on October 30 and as revenue when paid on November 25.

Under accrual, when the service is provided, you debit $5,000 to accounts receivable and credit $5,000 to service revenues. When payment arrives on November 25, you credit accounts receivable by $5,000 and debit cash by $5,000. You can then move that capital to other accounts using the same double-entry method.

Explaining Accrual to Non-Accountants

If you're not an accountant, think of accrual as using double-entry accounting, where you record payments or receipts in two accounts right when the transaction starts, not when money moves.

Key Differences and Methods

The main difference is that cash accounting records when payments are received, while accrual records when services or goods are provided or debt is incurred.

An accrual journal entry is the first record in the accounting process, made when a transaction occurs. The three main accounting methods are cash basis, accrual basis, and a hybrid called modified cash basis.

The Bottom Line

To wrap this up, accrual accounting credits and debits payments and expenses when they're earned or incurred. It stands apart from cash basis, where you record expenses on payment and revenues on receipt.

Accrual uses double-entry accounting with typically two accounts per transaction. This method is more accurate than cash basis because it tracks capital movement through your company and aids in preparing financial statements.