Under the accrual basis of accounting, revenues and expenses are counted when they are earned. This is different from the cash basis of accounting, where they are reported whenever cash actually flows in and out of the business. Most accountants consider the accrual accounting method to be a better measurement of profitability for income statement purposes.
The majority of companies use accrual accounting as their standard accounting practice, even though it is more complicated and subjective than cash accounting. Most companies have some forms of delayed accounts payable and accounts receivable, such as selling on credit or projects that produce revenue streams over a long period of time. These events have a real impact on the business's operations, even if no cash is immediately received.
For example, a company that sells a piece of furniture on credit records the sale immediately, not after all payments have finally been received. When payments have been received before a service has been provided or a good has actually been made and delivered, the accrual accounting method treats this event as a liability. The company recognizes revenue in the traditional way only when full payment has been received.
Almost always, accrual accounting treats the recognition of expenses based on the recognition of related revenue. This is known as the matching principle. This principle, as dictated by the generally accepted accounting principles (GAAP), applies to both the sale of goods and the rendering of professional services. Without this, financial statements would reveal very little useful information because readers would not have an accurate assessment of assets and liabilities.
Whenever a transaction is recorded during one accounting period, but cash revenue is not actually received until a subsequent accounting period, accountants call it accrued revenue. Similarly, accrued expenses relate to those expenses that are incurred during one period but paid in another. The accrual basis of accounting is mandatory for any businesses that maintain an inventory. For those with under $10 million in sales, a hybrid method of accrual and cash accounting may be used as long as the accrual method is used for sales, purchases and inventory items.
Enterprise software, such as QuickBooks, has become extremely popular for businesses and individuals. While many produce both cash and accrual basis reports, the default setting is almost always accrual.
While the accrual method does show the ins and outs of business income more accurately, it also makes it more difficult to know how much cash is actually on hand. Businesses that do not carefully monitor their cash flow separately from their accrual accounting could face serious cash flow problems. This is especially important for those businesses that rely heavily on credit accounts and delayed payments from their customers.