Accrual Accounting

Accrual Accounting

What it is

Accrual accounting records revenue when it is earned and expenses when they are incurred, regardless of when cash is exchanged. It matches revenues and related expenses to the same reporting period to present a more accurate picture of financial performance.

Key principles:
* Matching principle — recognize revenues and expenses in the same period.
* Double-entry bookkeeping — each transaction affects at least two accounts.

How it works

Journal entries are made when goods or services are provided or obligations arise, not when cash moves. Typical accrual entries include:
* Accounts receivable (asset) and revenue recorded when a sale is made on credit.
* Accounts payable (liability) and expense recorded when goods or services are received.

Example:
– Service provided for $5,000 on Oct 30:
– Debit Accounts Receivable $5,000
– Credit Service Revenue $5,000
– Payment received on Nov 25:
– Debit Cash $5,000
– Credit Accounts Receivable $5,000

Who must use it

• Companies with average gross receipts of $25 million or more over the prior three years are required to use accrual accounting for tax and reporting in many jurisdictions.
• Any business that carries inventory or routinely sells on credit typically must use accrual accounting regardless of size.
• Accrual accounting is recommended under GAAP and IFRS and is the standard for most medium and large businesses.

Benefits

• More accurate view of financial position and performance.
• Aligns revenues with the expenses that generated them, improving comparability across periods.
• Provides timely insight into expected cash inflows and outflows for planning and decision-making.

Drawbacks

• More complex and costly to implement and maintain than cash-basis accounting.
• Can obscure actual cash liquidity—profitability does not guarantee immediate cash availability.
• Requires stronger accounting controls and recordkeeping.

Accrual vs. Cash Accounting

Cash basis: record transactions only when cash is received or paid. Simpler and common for small businesses.
Accrual basis: record when transactions occur (earned/incurred), giving a fuller picture of ongoing operations.

When to prefer each:
* Use cash basis for very small operations with simple, immediate cash transactions and little or no inventory or credit sales.
* Use accrual basis for businesses with credit sales, long-term projects, inventory, or when external reporting requires GAAP/IFRS compliance.

Common terms

• Accrual journal entry — the initial record that recognizes revenues or expenses when they occur.
• Modified cash basis — a hybrid method combining elements of cash and accrual accounting.
• Double-entry — every transaction affects at least two accounts (debits and credits).

FAQs

Q: What’s the main difference between accrual and cash accounting?
A: Cash accounting records when cash changes hands; accrual accounting records when transactions are earned or incurred.

Q: What are the three accounting methods?
A: Cash basis, accrual basis, and a hybrid (modified cash basis).

Q: Is accrual accounting more accurate?
A: Yes for measuring economic activity and performance, though it may not reflect short-term cash availability.

Bottom line

Accrual accounting provides a clearer, period-matched picture of a company’s financial performance and position and is the standard for larger businesses and those with inventory or credit sales. It requires more sophisticated recordkeeping than cash accounting but supports better planning and comparability across reporting periods.