Accrual accounting is an accounting method used by businesses to record financial transactions in a way that matches revenues with the expenses incurred to earn them. Many small business owners, their accountants, and financial statement users prefer accrual accounting to other methods because it provides a more accurate picture of a company's income and expenses during a certain period.
What is accrual accounting?
The accrual accounting method requires companies to record revenues when they are earned and expenses when they have been incurred, regardless of when money actually changes hands. This differs from the cash basis of accounting, in which companies recognize revenues when the business collects payments and expenses when they are paid.
To record these transactions using accrual accounting, the company's chart of accounts usually includes one or more of the following:
- Accounts receivable (A/R) is an asset account representing money customers owe the business for goods or services received in the past. The receivable is typically collected within a few weeks.
- Prepaid expenses are assets representing money the company paid in advance for a product or service. Some common examples of prepaid expenses include rent, insurance, and estimated tax payments.
- Unearned revenues are liabilities representing money customers pay to a business in advance, before receiving goods or services. Some common examples of unearned revenue include service contracts and legal retainers.
- Accounts payable is a liability account representing money a business owes to a third party, usually for purchases of goods or services.
- Accrued expenses are liabilities representing costs the business has incurred but not yet paid. Common examples of accrued expenses include wages, utilities, and interest on an outstanding loan.
What are the benefits of using accrual accounting?
Cash accounting is easier than accrual accounting, but the accrual method has one major advantage.
Accrual accounting provides a clearer picture of how much money a business earned and spent during an accounting period. This can provide business owners and users of financial statements with a better overall understanding of the company's profitability.
Simply looking at the cash on hand at any moment doesn't provide an accurate picture of a company's overall financial position or results of operations. Accrual accounting provides more information on the business' future inflows and outflows, which makes evaluating its finances and planning for the future easier.
When are companies required to use accrual accounting?
Both U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) require organizations to use accrual accounting to record all revenues and expenses. This means all publicly traded companies are required to use the accrual basis.
Lenders may also require a company to issue GAAP financial statements to obtain a loan or line of credit.
For tax purposes, the IRS requires all businesses with average annual gross receipts of greater than $26 million over a three-year period to use accrual accounting.
Example of accrual accounting
To get a better understanding of accrual accounting, consider the following example.
A customer buys $1,000 worth of goods on credit. Using the accrual accounting method, the seller records $1,000 of revenue at the time of sale and increases Accounts Receivable by the same amount. The following month, the customer pays their invoice. When the seller receives the payment, it increases Cash by $1,000 and decreases Accounts Receivable by the same amount.
Choosing the cash or accrual accounting method is ultimately a management decision. It depends on the business' goals, resources, and financial requirements. Unless the business has more than $26 million in average gross receipts, it's free to adopt the method that best meets its needs. However, companies may want to consider accrual accounting—even when it's not required—to have better insight into business performance or because it eventually intends to seek outside financing.