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Accrual accounting is a method of tracking finances in which revenue and expenses are recorded in real time, when they’re earned or incurred, rather than recorded only after deposits or payments are actually made. Due to this feature, accrual accounting can give a business a more up-to-the-minute and accurate view of its financial standing than other techniques can. Learn more about accrual-based accounting and why some businesses use it while others don’t.
Key Points
• Accrual accounting records revenue and expenses when they’re earned or incurred rather than when cash actually changes hands.
• This method uses accounts receivable and accounts payable to track real-time financial health and match expenses to earned income.
• Key benefits include deeper profitability insights, clearer trend tracking, and better budget and cash flow management.
• Drawbacks of accrual-based accounting include more complexity, increased setup and compliance costs, and potential temporary misrepresentation of available cash.
• Businesses generating $32 million or more in average annual gross receipts over the three years prior are required by IRS rules to use accrual accounting.
What Is Accrual Accounting?
Accrual accounting is an accounting method that requires recording business income and expenditures as soon as they’re made rather than waiting for an invoice’s payment to be received or a bill to be paid. This system can help a business have a more detailed and up-to-date view of its overall finances and profitability. It can also be important when a company is seeking funding or contemplating a small business loan to scale the enterprise.
Accrual Accounting vs Cash Accounting
Here’s how accrual accounting compares to cash accounting, another popular accounting method:
• Accrual accounting tracks revenue within a specific time period. So if services were provided or products were delivered, the earnings would be recorded, even if payment wasn’t yet made. Similarly, if a small business expenditure is incurred on the first of the month, that’s when it would be recorded, even if it isn’t going to be paid for, say, 30 days. In this way, expenses and income can be matched, so a business owner can better see the impact of an outlay of funds.
• Cash accounting records transactions only when money actually changes hands. So if a business owner were to bill a client $500,000 on February 5 for services provided but only receives the payment on March 12, the income wouldn’t be added to the ledger until the latter date. Similarly, if the business purchased $100,000 of office machinery on July 10 but the terms were Net 60, the transaction would only be recorded in September, when the bill was paid.
Accrual accounting can give a more detailed and accurate picture of a company’s financial standing than cash accounting. It can also help business management identify expenses that may be contributing to or hindering growth.
How Accrual Accounting Works
Accrual accounting works by recording income when it’s earned vs. when payment is received and expenses when they’re incurred rather than by when they’re paid.
Earnings are noted when services or goods are provided, even if funds have not yet been received. An accounts receivable entry is created to track the payment owed.
In much the same way, when an expense is incurred, it’s recognized at that moment, even if an invoice won’t be paid from your small business checking account for a period of time. An accounts payable entry is generated to track the fact that payment will be due eventually.
Another aspect of accrual accounting is that it uses a matching principle, meaning that for a given reporting period, both income and expenses are aligned. A company can more clearly discern which expenditures led to how much income being earned in a specific time period. It could also reveal if a cash flow loan is required at a specific juncture in a business’s evolution because expenditures and earnings aren’t well aligned.
Accrual-based accounting can better reflect the true operational and financial standing of a business, regardless of when cash actually changes hands.
Types of Accruals
When you’re delving into accrual accounting, it can help to understand the different types of accruals, such as accrued revenue and accrued expenses. Here’s a closer look at these accruals’ meanings.
• Accrued revenue (which also may be called accrued assets) is money earned but not yet received. Typically, it reflects a situation in which a business has supplied goods or services but hasn’t yet invoiced the customer or received funds through another company’s small business credit card, small business check, or other form of payment.
• Accrued expenses (which may also be referred to as accrued liabilities) are expenditures that have been incurred but haven’t been paid yet. This could be office equipment that was purchased but for which an invoice hasn’t been received yet or wages owed to employees that won’t be paid until the end of the month.
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Pros and Cons of Accrual Accounting
Accrual accounting, like many aspects of finance, has its advantages (such as enhanced budget control) and disadvantages (like more complicated financial tracking).
Pros of Accrual Accounting
Here are the main upsides of accrual accounting.
• It helps you obtain a deeper knowledge of how your expenses correlate to your income. This can enhance the accuracy of insights into your company’s financial standing and profitability.
• It can strengthen your business’s ability to manage its cash flow, credit, and budget. This is accomplished via more granular tracking of accounts receivable and accounts payable and how they match up, even before bills are paid and payments deposited.
• It allows better tracking of long-term accounts and indicates how finances and profitability are trending.
• It can deliver more on-target and detailed financial intel for stakeholders, illuminating how well a business is faring in terms of its operations and finances.
Cons of Accrual Accounting
Next, consider the disadvantages of accrual accounting, such as the level of complexity it can demand.
• It tends to involve complicated setup, tracking, and record keeping to keep tabs on accounts receivable and accounts payable prior to money being exchanged, as well as to match expenses and earnings during a given time period.
• It requires a specially trained (and perhaps pricier) accounting team to manage the accrual accounting process. It may also incur more systems and compliance costs.
• It might provide an inaccurate sense of cash flow, since money hasn’t yet traded hands. If, say, it accounts for selling $1 million in products, but the buyer goes bankrupt and never pays what they owe, the availability of income could be misrepresented in the moment.
• It could heighten the risk of errors in financial reporting (especially since estimations about unpaid bills can be involved in accrual accounting), which may trigger compliance issues and audits.
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Who Is Required to Use Accrual Accounting?
It’s worth noting that accrual accounting is required of public companies as part of their adherence to generally accepted accounting principles (GAAP). In addition, businesses with $32 million or more in average annual gross receipts over a period of three years prior are expected to use accrual accounting. Some small businesses may also choose to use the method if it helps them get a clearer picture of their operational and financial situations.
While accrual accounting can give a business greater insight, it can also involve more time and money to manage, and it may open the door to certain types of errors and issues (more on that below).
Best Practices for Accrual Accounting
When your business is considering adopting accrual accounting, keep these best practices in mind.
1. Determine how to recognize recurring expenditures (employee payroll, rent, utility bills) so they can be tracked.
2. Adopt practices that will allow you to recognize revenue appropriately. For instance, if you have a subscription business, determine how to reconcile revenue, or if an agreement involves bundled products, carefully consider how to capture that. (Fine-tuning your accounting may reveal if perhaps a loan for an e-commerce business could be useful.)
3. Revisit accrued payments and earnings regularly to scan for unpaid bills that need to be written off and other transactions that can impact profitability.
4. Keep in mind potential liabilities (product returns, legal fees, staffing costs) that might occur. You may want to plan how to cover them financially and note this information on your accounting documents.
5. Divide duties for authorizing, recognizing, and reconciling transactions. By having more personnel involved, you may mitigate the risk of human error or fraud.
6. Be sure that all accrual procedures and transactions are well documented. This allows for ease of communication with shareholders and can be helpful in the event of an audit.
Taking these steps can help accrual accounting run more smoothly and securely.
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The Takeaway
Accrual accounting is an accounting method that involves tracking accounts payable and accounts receivable when income is earned and expenses are incurred, rather than waiting until the money for these transactions actually changes hands. While it can provide accurate insights about which expenses lead to profit and how a business is faring financially, it may require more time, effort, and money to manage than other accounting methods.
Accrual accounting can contribute to a business’s growth and success, but sometimes a small business loan can also help.
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FAQ
What does accrual mean in accounting?
In accounting, accrual’s meaning is recording a transaction, whether earnings or expenditures, before money has been exchanged.
What is an example of accrual-based accounting?
An example of accrual-based accounting would be that, when a business delivers $10,000 worth of products on February 15, that revenue is recorded in the February financial records, even if the invoice is only issued and paid a month later, in March.
What is the difference between accrued revenue and accrued expenses?
To understand the difference between accrued revenue and accrued expenses, know that with accrued revenue, earnings are recognized for accounting purposes when goods and services are provided, not when they’re paid for. For accrued expenses, expenditures are recorded when purchases are made rather than waiting until they’re invoiced and paid.
Do small businesses have to use accrual accounting?
Small businesses don’t have to use accrual accounting, but some prefer to. The IRS guidelines require that both publicly traded companies and businesses that took in $32 million or more on average annually over the three years prior use accrual accounting.
How does accrual accounting differ from deferred revenue?
Accrual accounting records earnings and expenditures when they happen, without waiting for money to change hands. Deferred revenue is a component of accrual accounting as it plays out on financial statements. It refers to payments your company may get before it delivers the goods or services being paid for. Typically, that amount would initially be recorded as a liability on your balance sheet. As you deliver your goods, that liability then gets transferred over time to revenue on your income statement.
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