What Is Accrual Accounting?
Accrual accounting is one of two accounting methods; the other is cash accounting. Accrual accounting measures a company's performance and position by recognizing economic events regardless of when cash transactions occur, whereas cash accounting only records transactions when payment occurs.
- Accrual accounting is an accounting method where revenue or expenses are recorded when a transaction occurs rather than when payment is received or made.
- The method follows the matching principle, which says that revenues and expenses should be recognized in the same period.
- Cash accounting is the other accounting method, which recognizes transactions only when payment is exchanged.
How To Decipher Accrual Accounting
How Accrual Accounting Works
The general concept of accrual accounting is that economic events are recognized by matching revenues to expenses (the matching principle) at the time when the transaction occurs rather than when payment is made or received. This method allows the current cash inflows or outflows to be combined with future expected cash inflows or outflows to give a more accurate picture of a company's current financial position.
Accrual accounting is considered the standard accounting practice for most companies except for very small businesses and individuals. The Internal Revenue Service (IRS) allows qualifying small businesses (less than $25 million in annual revenues) to choose their preferred method. The accrual method does provide a more accurate picture of the company's current condition, but its relative complexity makes it more expensive to implement.
This method arose from 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, affect a company's financial condition at the time of a transaction. Therefore, it makes sense that such events should also be reflected in the financial statements during the same reporting period that these transactions occur.
Under accrual accounting, firms have immediate feedback on their expected cash inflows and outflows, which makes it easier for businesses to manage their current resources and plan for the future.
Accrual accounting provides a more accurate picture of a company’s financial position some small businesses use cash accounting.
Accrual Accounting vs. Cash Accounting
Accrual accounting can be contrasted with cash accounting, which recognizes transactions only when there is an exchange of cash. Accrual accounting is almost always required for companies that carry inventory or make sales on credit.
For example, consider a consulting company that provides a $5,000 service to a client on Oct. 30. The client receives the bill for services rendered and makes a cash payment on Nov. 25. 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 company receives payment. A company that uses the cash accounting method will record $5,000 revenue on Nov. 25.
Accrual accounting, however, says that the cash method is not 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 the revenue when the clients' services are concluded even though the cash payment is not yet in the bank. Revenue will be recognized as earned on Oct. 30. 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 has 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 the goods were received. The accrued expense will be recorded as an account 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.
What Are the Types of Accrual Accounts?
There are various types of accrual accounts. The most common include accounts payable, accounts receivable, goodwill, accrued interest earned, and accrued tax liabilities.
Accounts payable refers to debts a company incurs when it receives goods or services from its vendors before it has actually paid for them. Using the accrual accounting method, when a company incurs an expense, the debt is recorded on the balance sheet as an accounts payable liability and on the income statement as an expense.
What Is an Example of Accrual Accounting?
Suppose an appliance store sells a refrigerator to a customer on credit. Depending on the terms of its agreement with its customers, it may take many months or years before the store receives payment in full from the customer for the refrigerator. Using the accrual accounting method, the store will record the accrued revenue from the sale when the refrigerator leaves the store, not at some date in the future.
Does the IRS Require Accrual Accounting for Companies?
While the IRS does not require a single method of accounting for all businesses, it does impose certain limitations that impact which accounting method a company can use. For example, a company cannot use the cash method if it is a corporation (other than an S corporation) with average annual gross receipts greater than $25 million for the prior three tax years. In these situations, the IRS requires the corporation to change to an accrual accounting method.
What Is Modified Accrual Accounting?
Modified accrual accounting is an alternative accounting method that combines elements from accrual accounting with cash basis accounting. Because modified accrual accounting does not comply with generally accepted accounting principles (GAAP), public companies do not use it. However, the accounting method is widely accepted and used by government agencies.