Accrual base accounting is one of two leading accounting methods. It is the recommended bookkeeping technique for giving a precise financial picture of a business’s operational activities. When a company uses the accrual method of accounting, revenue and expenses are recognized when they are incurred rather than when the corresponding cash is actually exchanged. This indicates that businesses record revenue when it is earned, rather than when the money is actually collected by the business. It also involves recognizing expenses when the corporation becomes legally obligated to pay for them, rather than when the money is actually paid out.

What is accrual base accounting?

The matching principle and the revenue recognition principle are both combined into a single concept under the accrual system of accounting. According to the matching principle, costs should be deducted from revenue in the same accounting period that it was used to produce. According to the principle of revenue recognition, income should be recorded at the point in time at which it is earned or realized. This means that it should be recorded when an organization carries out the activities that earn it the right to receive the revenue.

In general, accrual base accounting makes the linkages between income and expenses clearer, so providing a better insight into the business’s profitability. Additionally, it provides a more realistic representation of the assets and liabilities held by a corporation on its balance sheet. Accounting on an accrual basis is the only approach that is permitted by the Generally Accepted Accounting Principles (GAAP) and is required by the Securities and Exchange Commission (SEC) for publicly traded corporations.

How does accrual base accounting work?

Under the accrual method of accounting, a business will record revenue for the current period in which it was earned and will record expenses for the current period in which they were incurred. This occurs frequently before—and occasionally after—the organization actually receives or distributes money.

In order for accrual base accounting to function properly, “accruals” must first be recorded on the balance sheet. These “accruals” serve as “placeholders” for cash occurrences. An example of this would be a company’s accounts receivable, which are asset accounts that show revenue that a company has received but for which it has not yet been paid. Accounts payable are another type of liability account that indicate payments that the company owes but has not yet paid for.

Examples of accrual base accounting

Revenue example

A straightforward illustration of the use of accrual base accounting for revenue is the situation in which a business makes a sale to a client on trade credit. In this scenario, the buyer agrees to pay the seller within a predetermined amount of time following the completion of the transaction. In this scenario, income is generated prior to the receipt of cash, generally as a result of the transfer of ownership of items or the completion of a service.

Expenses example

A typical illustration of the accrual method of accounting for expenses is when a corporation purchases inventory on credit.

Other examples

• When annual or multi-year contracts, subscriptions, or memberships are paid all at once, the revenue or cost is divided over the course of the contract or subscription. 
• The business records each expense for the period it relates to for accrued payroll, vacation, or employee benefits even though the money is paid at a later time.
• When bills for utilities or rent are issued after the time period to which they apply, the business accrues the expense while using the rented property or utilities.
• Even when the company pays the tax when required by the IRS, it records the income tax or sales tax due on revenue at the same period it recognizes the revenue.
• Even though interest on loans is paid at a later date, it is recorded while the principal is still outstanding.

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When to use accrual base accounting

The accrual base accounting technique must be used for any regulatory filing that must follow GAAP, such as a company’s yearly 10-K filing with the SEC. The vast majority of investors, lenders, and other financial institutions look for GAAP-compliant financial statements when they analyze a company. This is one of the main explanations for why accrual accounting is used more frequently.

However, there are a few exceptions to this rule, most of them relate to income taxes. Small businesses with annual revenues of under $25 million are given the option by the Internal Revenue Service (IRS) to base their tax filing on accrual accounting or cash accounting. Businesses organized as partnerships, S-corporations, and sole proprietorships can all use cash accounting. If you decide to change your method of accounting, keep in mind that additional paperwork must be completed to the IRS.

Accrual base accounting best practices

When using the accrual method of accounting to record transactions, it is imperative that you completely document the reason behind every adjusting entry that is made. This is necessary in order to ensure that someone evaluating the explanation for the entry at a later time will have a better understanding of why it was made. This is of the utmost significance in the event that the entity doing the evaluation is an independent auditor for the company.

Setting up adjusting entries such that they automatically cancel themselves out in the period that follows is another recommended best practice. This clears out the entries from the accounting system, which reduces the possibility of discovering stray entries in the accounting records as part of the process of closing up the books at the end of the fiscal year and having to undo them at that time.

Advantages of accrual base accounting

The accrual method of accounting is the type of accounting that the vast majority of businesses prefer to utilize since it gives a more realistic picture of a company’s finances. Although it’s possible that lenders and investors will require you to employ this technique, even if they don’t, keeping a consistent set of key performance indicators can give your business the appearance of being more dependable, which can increase your chances of getting funded. Additionally, accrual accounting enables you to maintain GAAP compliance, which is an excellent practice that could become important in the future.

Even new businesses that first use the cash method of accounting out of convenience nearly usually switch to the accrual foundation of accounting by the time they need to raise outside funding. As a result, even if you don’t follow this standard at the now, you’ll probably have to in the future.

Should you apply the accrual base accounting method to your business?

Accrual base accounting is generally not the best strategy for your business to adopt if cash transactions are the sole way your firm makes money and covers its expenses. For the vast majority of other businesses, particularly those that provide credit to their customers and/or use credit with their vendors, accrual accounting paints a more accurate picture of an organization’s overall financial health than cash-basis accounting does. In general, anytime there is a greater lag between bills and payments, the case for accrual-based accounting grows stronger. Even if the business is small, product-based companies that keep inventory often employ accrual accounting. This is because the cost of products sold is improperly accounted for under the cash method of accounting, which lowers gross profit.

Additionally, all publicly traded businesses and companies with yearly revenues greater than $25 million must use accrual base accounting. Therefore, you will be compelled to utilize this specific type of accounting if and when your business reaches a certain degree of success.

How does accounting software help with accrual base accounting?

The time and work that is required to maintain the books and records are some of the primary reasons why firms are hesitant to utilize accrual base accounting. It is more difficult to effectively handle accounts payable, accounts receivable, and prepaid or deferred assets than it is to merely track cash coming in and cash going out using the cash basis technique. In addition, using the accrual method forces businesses to close the books more frequently (i.e. monthly, rather than annually). In addition, businesses typically do weekly or biweekly management of subsidiary ledgers such as accounts receivable and accounts payable.

Implementing accounting software that can automate and streamline the process, hence decreasing errors and human expense, is one way to significantly lessen the likelihood that adopting accrual accounting will be a barrier for a business. Accrual accounting is simplified by the fact that the main feature of most accounting software already includes recurring journal entries, reconciliations of subsidiary ledgers, and balancing, all of which are essential components of accrual accounting.

Key takeaways

• Accrual base accounting involves recording revenue or expenses at the time a transaction takes place as opposed to recording them when a payment is received or paid.
• The matching principle, which states that an entity’s earnings and expenses should be recognized in the same period, is adhered to by the approach.
• Accrual base accounting uses the double-entry accounting method.
• Companies that have annual revenue of at least $25 million on average over the course of three years are required to use accrual base accounting.
• The alternative style of accounting is known as cash accounting, and it registers transactions only when payment is actually exchanged.

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