Accrual Accounting Explained: Meaning, Examples and Benefits
- Published: 14 January 2025
- 8 min read
- Running a Business
Heather Cameron
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Accrual accounting records income and expenses as they’re earned or incurred, providing a clearer view of a business’s financial health. This guide explores how it works, its benefits, and whether it suits your business needs.
Key Takeaways
- Accrual accounting ensures that revenue and expenses are recorded when they occur, offering a precise snapshot of a business’s financial performance, rather than just focusing on cash flow.
- By tracking receivables and payables, accrual accounting improves cash flow forecasting, helping businesses plan for future needs and make more informed decisions.
- Accrual accounting is often required for regulatory compliance and presents a more complete financial picture, which can be crucial for attracting investors or securing loans.
- Accrual accounting supports better financial management by enabling businesses to analyze trends over time, compare performance across periods, and evaluate the true profitability of their operations.
What Is Accrual Accounting?
Accrual accounting is an accounting method where financial transactions are recorded when they are earned or incurred, rather than when cash is received or paid. This method provides a more accurate and comprehensive view of a business's financial performance and obligations by aligning revenues and expenses with the periods in which they occur.
For instance, revenue is recognised as soon as a product or service is delivered to a customer, even if the payment is received later. Similarly, expenses are recorded when a company incurs a cost, such as receiving goods or services, even if payment is deferred.
Example
Imagine Jack, a freelance copywriter, completes a project for a client in December and issues an invoice for the work. Even if the client pays him in January, Jack would record the income in December because that’s when the service was performed. On the other hand, if Jack hires a graphic designer in December and receives an invoice for their work, he would log the expense in December, regardless of when he pays the bill.
By using accrual accounting, Jack ensures that his financial records reflect the true economic activity of his business during the reporting period.
How Accrual Accounting Works
The accrual accounting method operates on two key principles:
- Revenue Recognition Principle: Revenue must be recorded in the accounting period when it is earned, regardless of when the payment is actually received. This principle ensures that income is reported in the correct period.
- Matching Principle: Expenses should be matched to the revenues they helped generate, and both should be reported in the same accounting period. This principle avoids misrepresenting profits by ensuring that related costs and revenues appear together on the financial statements.
Example
If a company delivers a product to a customer in December but the customer pays in January, the revenue is recorded in December. Similarly, if the company incurs advertising costs in December to generate sales for that month, the expense is also recorded in December, even if the payment is made later.
This approach provides a clearer view of the company’s performance, making it easier for business owners, investors, and managers to make informed decisions based on accurate financial data.
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Accrual Accounting Entries
In accrual accounting, transactions are recorded as they occur, not when cash is exchanged. This includes:
- Revenue Entries: Revenue is recognised when it is earned. For instance, if a company makes a sale on credit, the revenue is recorded at the time of sale, even though the cash payment may come later.
- Expense Entries: Expenses are logged when the obligation arises. For example, if a business receives services in December but pays for them in January, the expense is recorded in December.
Additionally, accruals are used to account for revenues or expenses that have been incurred but not yet recorded. These entries ensure that financial statements reflect the company's true performance for a given period.
Example
- Revenue Accrual: A company completes a project in December and expects payment in February. The revenue was recorded in December when the service was delivered.
- Expense Accrual: An electricity bill for December is received in January. The expense is recorded in December, aligning with when the utility was consumed.
By using accrual accounting, businesses can produce financial statements that are accurate, reliable, and compliant with accounting standards like GAAP or IFRS, providing stakeholders with valuable insights into the company’s financial health.
The Difference Between the Accrual Accounting and the Cash Basis Accounting
Cash basis accounting has the opposite approach: transactions are recorded once payment is received or paid.
Example
If Jack used the cash-based method, he would consider his income earned only once he gets the money.
Cash basis accounting is not for everyone. The method can only be used by businesses with a yearly turnover of less than £150,000. LLC's, LLP's, and publicly traded companies are prohibited from keeping track of their finance this way. On top of that, there are some industry limitations.
Cash basis accounting
If you run a small business, cash basis accounting may be more suitable than accrual accounting. This method simplifies tax calculations by focusing on cash received and paid, helping you avoid paying tax on sales for which you haven’t yet received payment.
However, the cash basis may not be ideal if your business holds a high level of stock. In such cases, your books may show losses since there’s no cash profit until some of the stock is sold.
Accrual basis accounting
Using an accrual basis can be challenging in certain scenarios and requires the bookkeeper or accountant to pay extra attention to the books. For example, there’s a risk of recording a sale prematurely. If this happens at the end of an accounting period, you risk paying more tax than necessary.
The accrual basis, however, might suit you better if you need to present your financials to a bank for loan approval. For instance, if Edward went to the bank with £14,000 losses under cash accounting compared to £15,000 profit using the accrual method, his case for approval would be much stronger.
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Example of How Cash vs Accrual Accounting Affects Financial Reporting
There is a guy named Edward who owns an online shop for Christmas decorations. Let's take a look at his transactions:
- He sold £30,000 worth of goods on January 1st but received the money for it on March 30th.
- He Purchased stock of £8,000 on January 1st and paid it the same day
- His website maintenance invoice came in on March 15th. He paid it on April 15th.
- His marketing guy sent him an invoice on February 1st. Edward paid for it the same day.
Let's take a look at his P&L at the end of the first quarter of 2024. It's recorded using both methods.
Particular | Cash Basis | Accrual basis | Transaction Date | Payment/ Receipt date | Notes |
|---|---|---|---|---|---|
| Sales | 0 | 30000 | 01/01/2024 | 30/04/2024 | Under the cash basis, the sale was not reported until Edward got the money on 30.04.2024. But under the accrual basis, as soon as he earned the deal, he recorded it. |
| Purchase | -8000 | -8000 | 01/01/2024 | 01/01/2024 | |
| Website Maintenance | 0 | -1000 | 5/03/2024 | 15/04/2024 | On a cash basis, the transaction is recorded when payment is made to the supplier. Cash is paid after the reporting period and therefore not recorded. |
| Advert Ex | -6000 | -6000 | 01/02/2024 | 01/02/2024 | |
| P&L | -14000 | 15000 | - | - | Under the cash basis, it seems as if Edward made a loss of £14,000. In reality that is just a cash position of the business. On an accrual basis, the £30,000 in sales are recorded right away and P&L shows £15,000 in profit. |
Advantages of Accrual Accounting
Historically, cash basis accounting was favoured for its simplicity, particularly by small businesses. However, modern accounting software has made both cash and accrual accounting much easier to manage, allowing businesses to track financial balances with just a few clicks.
Accrual accounting offers several key benefits:
- Accurate Financial Reporting: Records income and expenses when they occur, providing a clearer picture of profitability and financial health.
- Improved Cash Flow Forecasting: Tracks receivables and payables, helping businesses predict future cash flow more accurately.
- Informed Decision-Making: Offers insights into actual business performance, beyond just cash in hand, for better decision-making.
- Time-Saving and Automation: Modern software automates processes, reducing manual entry and errors, while saving valuable time.
- Better for Investors and Lenders: Provides a comprehensive view of financial health, often required by investors or lenders for funding or loan approval.
In summary, accrual accounting helps businesses achieve more accurate, efficient, and strategic financial management.
When To Use Accrual Accounting Method
The accrual accounting method is ideal for businesses that deal with larger volumes of transactions, have inventory, or require accurate financial reporting for long-term decision-making. It's especially useful if you need to manage complex revenue streams, such as sales on credit, or when seeking external funding, as it provides a clearer view of your financial health. Additionally, if your business needs to comply with accounting standards or regulations, accrual accounting is often the preferred method.
If your business has growth ambitions, accrual accounting also supports better forecasting, allowing you to plan for the future with more reliable financial data.
Summary
Accrual accounting provides an accurate, timely reflection of business performance by recording transactions when they occur. This method is essential for companies looking for detailed financial insights, improved cash flow management, and support for growth. Whether managing revenue streams or preparing for investment, accrual accounting offers the necessary tools for strategic decision-making.
FAQ
What is the definition of accrual accounting?
Accrual accounting is an accounting method where revenue and expenses are recorded when they are earned or incurred, regardless of when the cash is actually received or paid. This method provides a more accurate picture of a company's financial position by matching income and expenses to the period in which they occur.
What are accrual accounting entries?
Accrual accounting entries are journal entries made to record revenues and expenses that have been earned or incurred but not yet received or paid. Common examples include accounts receivable for revenues earned but not yet received and accounts payable for expenses incurred but not yet paid.
Can you explain the accrual concept in accounting?
The accrual concept in accounting is the principle that financial transactions should be recognised in the period in which they occur, rather than when the cash is exchanged. This ensures that financial statements reflect a company's performance and financial position accurately, adhering to the matching principle.
What are some common accrual accounting examples?
Examples of accrual accounting include:
- Recording revenue from a service performed in December, even if the payment is received in January.
- Recording expenses for utilities used in a month, even if the bill is paid the following month.
- Recognising interest income that has been earned but not yet received.
- Accruing salaries for employees for work done but not yet paid at the end of a reporting period.
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