Accrual Accounting

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What is 'Accrual Accounting'

Accrual accounting is an accounting method that measures the performance and position of a company by recognizing economic events regardless of when cash transactions occur. The general idea is that economic events are recognized by matching revenues to expenses (the matching principle) at the time in which the transaction occurs rather than when payment is made (or received). This method allows the current cash inflows/outflows to be combined with future expected cash inflows/outflows to give a more accurate picture of a company's current financial condition.

BREAKING DOWN 'Accrual Accounting'

Accrual accounting is considered to be the standard accounting practice for most companies, with the exception of very small businesses. This method provides a more accurate picture of the company's current condition, but its relative complexity makes it more expensive to implement.

The need for this method arose out of the increasing complexity of business transactions and a desire for more accurate financial information. Selling on credit and projects that provide revenue streams over a long period of time affect the company's financial condition at the point of the transaction. Therefore, it makes sense that such events should also be reflected on the financial statements during the same reporting period that these transactions occur.

Accrual accounting is the opposite of cash accounting, which recognizes transactions only when there is an exchange of cash. For example, consider a consulting company that provides a $5,000 service to a client on October 30th. The client receives the bill for services rendered and makes her cash payment on November 25th. The entry of this transaction will be recorded differently under the cash and accrual methods. The revenue generated by the consulting services will only be recognized under the cash method when the money is received by the company. A company that uses the cash accounting method will record $5,000 revenue on November 25th.

Accrual accounting, however, says that the cash method isn't accurate because it is likely, if not certain, that the company will receive the cash at some point in the future because the services have been provided. The accrual method recognizes revenue when the services provided for the client are concluded even though cash isn't yet in the bank. Revenue will be recognized as earned on October 30th. The sale is booked to an account known as accounts receivable, found in the current assets section of the balance sheet.

A company that incurs an expense that it is yet to pay for will recognize the business expense on the day the expense arises. Under the accrual method of accounting, the company receiving goods or services on credit must report the liability no later than the date they were received. The accrued expense will be recorded as an accounts payable under the current liabilities section of the balance sheet, and also as an expense in the income statement. On the general ledger, when the bill is paid, the accounts payable account is debited and the cash account is credited.

Under accrual accounting, firms have an immediate feedback of their expected cash inflows and outflows, which makes it easier for businesses to better manage their current resources and plan effectively for the future.

For more on Accrual Accounting and other accounting basics, check out our Accounting Basics Tutorial.