Accrual accounting records financial transactions when they're earned or incurred, rather than when you send or receive cash.
Unlike cash accounting, which only records transactions when money changes hands, accrual accounting provides a more accurate picture of a business's financial health by aligning revenues with the expenses related to generating them, regardless of payment timing.
Here, we'll cover everything you need to know about accrual accounting and when it makes sense for your business.
What is accrual accounting?
Accrual accounting records income and expenses as they occur, regardless of when you exchange cash. This method lets you capture the economic activity taking place over a given period, so it provides a more accurate reflection of your financial position and results of operations.
Using accrual accounting, you can better understand business performance because your financial statements don't just show cash inflows and outflows — they also reflect outstanding obligations (i.e., accounts payable, accrued expenses, and unearned revenue) and assets (i.e., accounts receivable and prepaid expenses).
Accrual accounting differs from cash accounting, where you record transactions when you receive or pay money. Cash accounting is more straightforward but doesn't always reflect the complete financial picture — especially if you sell to customers or buy from suppliers on credit.
Small businesses can usually choose whether to keep their books on the cash or accrual method. Still, the accrual accounting method is required for companies that issue generally accepted accounting principles (GAAP) basis financial statements.
What's an accrual?
An accrual is an entry in your books that reflects revenue or expenses earned or incurred but not yet paid or received in cash.
For example, say you deliver goods to a customer in December but don't receive payment until January. Under accrual accounting, you record the revenue in December because that's when the sale occurred. Along the same lines, if you receive a service in December but don't pay for it until January, the accrual method of accounting requires you to record the expense in December.
How accrual accounting works
Accrual accounting works by recording revenues and expenses when you earn or incur them, not when cash changes hands.
Here's how it works in practice:
Recognize revenue when earned
In accrual accounting, you record revenue when you deliver a product or service, even if the customer has not yet paid.
For example, say you deliver a product in September according to the terms of your contract with a customer. However, your customer doesn't pay for the product until October. You still record the revenue in September.
Record expenses when incurred
You record expenses when you incur them, not when you pay the invoice.
For example, say you receive a service in June but pay the bill in July. You still record the expense on your books in June because that's when you became obligated to pay.
Adjusting entries
The accrual method requires adjusting entries to ensure your income and expenses align with the actual financial activity during a period. For example, if employees earn wages in December but you don't pay them until the first payroll in January, you need to make an adjusting entry to account for the unpaid wages in December.
Once you cut the paychecks in January, you reverse the accrual.
Benefits of accrual accounting
While accrual accounting is more complex than cash accounting, it offers several advantages for businesses, particularly those aiming to grow, attract investors, or secure financing. Here are some of those benefits:
- More accurate financial picture. Accrual accounting gives you a clearer picture of company performance. By matching income and expenses to the correct period, you have a more realistic view of profitability and cash position, which is crucial for managing day-to-day operations and planning for the future.
- Better cash flow management. Although accrual accounting doesn't track cash payments directly, it provides better insight into upcoming payments and receivables. By keeping track of what is owed to and by the business, you can manage cash flow more strategically, avoiding surprises and ensuring you have the cash needed to cover expenses when they come due. This foresight allows you to take corrective action before cash shortages arise, improving financial stability.
- GAAP compliance. Publicly traded companies and other businesses that issue GAAP-basis financial statements must use the accrual method of accounting. GAAP is the standard financial accounting framework in the United States, so you may need to use it if you're trying to get business loans, attract outside investors, or work with big corporations.
- Enhanced credibility with lenders and investors. Even if you're not required to use the accrual accounting method, lenders and investors usually see businesses using it as more credible and reliable. Since the accrual method provides a complete picture of your company's financial standing—including unpaid obligations and future income—financial institutions and investors are better able to assess the business's ability to repay loans or generate returns on investments. This can improve your chances of securing financing or attracting potential investors.
Accrual accounting principles
Accrual accounting is built on two fundamental principles: the matching principle and the revenue recognition principle. Being aware of these principles helps you understand how accrual accounting works in practice.
Matching principle
The matching principle requires businesses to record expenses in the same period as the revenues they help generate. This means that if you incur a cost to produce income in a specific period, you should record it in that period—even if you receive the payment at a later date.
For example, you purchase 100 inventory units in August at $100 each. As long as the product sits in your inventory, it doesn't generate revenue. But when you sell the units for $300 each in October, you match the $10,000 cost of goods sold with the $30,000 of revenue generated in that accounting period. In other words, you book the sales and cost of goods sold (an expense) in October when you generated the revenue.
If you used cash basis accounting, you would record $10,000 of expenses in August and $30,000 of income in October.
Revenue recognition principle
The revenue recognition principle says companies should recognize revenue is recognized when earned, regardless of when it receives the payment. In other words, businesses record revenue when they provide goods or services, not when the customer pays.
For example, if you complete a project in November but don't receive payment until January, you still recognize the revenue in November, as that's when you completed the service. This principle ensures your financial statements reflect the true economic activity of the business for the accounting period.
The matching and revenue recognition principles work together to provide a more complete and accurate financial picture, aligning income and expenses with the correct periods so you can better understand your company's profitability and financial health.
Basics of accrual accounting entries
Next, let's review some typical accrual accounting entries.
Accounts receivable (AR)
When you provide goods or services but haven't yet received payment, creating an AR entry tracks the money owed to the business by customers.
For example, say you provide consulting services in October and invoice the client for $5,000. Under accrual accounting, you record the $5,000 revenue in October by making the following entry:
When you receive payment in November, you make the following payment to reverse the receivable and record the cash deposit:
Accounts payable (AP)
When you incur an expense but haven't yet paid the vendor, an AP entry represents the money you owe to suppliers.
For example, you receive an order of office supplies on December 20. You make the following entry to record the expense in December when you received the supplies:
When you pay the $1,000 invoice when it's due 30 days later in January, you make the following entry:
Prepaid expenses
A business has prepaids when it pays for goods or services in advance, but receives the benefit from those goods or services over multiple periods. The matching principle requires you to recognize the expense gradually as you receive the benefits.
For example, say your business pays $12,000 on January 1 for a one-year insurance policy. Instead of recognizing the entire $12,000 as an expense in January, you record $1,000 of insurance expense each month to match the benefit received. The entry on January 1 is:
At the end of each month, you make an adjusting entry to recognize the monthly expense and take that amount out of the prepaid expense account:
Accrued salaries and wages
You use accrued salaries and wages when employees work in one accounting period but don't get paid until the following accounting period.
For example, say your employees earn $3,000 in wages in the last week of December but won't receive their paychecks until the first week of January. You would make the following entry to accrue salary and wages expense on December 31:
Automate accrual basis accounting with the right tools
Accrual accounting offers several benefits, from improved financial reporting to better cash flow management, so it makes sense if you want to grow, secure financing, or even potentially take your company public someday.
Implementing accrual accounting can seem complex, but BILL simplifies the process with features designed to automate accounts payable and receivable, including capturing, approving and paying vendor invoices and sending and tracking invoices sent to customers.
Accrual accounting FAQs
Here are answers to some common questions about accrual accounting.
What is the difference between accrual accounting vs cash basis accounting?
Cash basis accounting records transactions only when a business receives or pays cash, while accrual accounting records revenues and expenses when they are earned or incurred. Cash basis accounting is simpler, but the accrual method provides a more accurate financial picture.
What are the three accounting methods?
The three primary accounting methods are cash accounting, accrual basis, and modified cash basis. The modified cash basis combines elements of both cash basis accounting and accrual accounting for more flexible financial reporting.
There's no standard as to what modifications are allowed when a business uses the modified cash basis method. For example, the company might record income using the accrual method but recognize expenses using the cash method. In that case, it would have receivables on the balance sheet, but no payables.
This lack of consistency is why the modified cash basis method isn't allowed under generally accepted accounting principles or International Financial Reporting Standards (IFRS).
What's the difference between prepaid expenses vs. accrued expenses?
Prepaids are payments made for future services or benefits, while accrued expenses are incurred but unpaid costs. Prepaids are assets; accrued expenses are liabilities until settled.
