How Does Accrual Accounting Work and Why Does It Matter? 

Accrual accounting is a method used by businesses to record revenues and expenses when they are earned or incurred, not when the cash is actually received or paid. 

In simpler terms, if a company delivers a 

 product or service but hasn't received payment yet, they still record that revenue. Similarly, if they receive a service or goods but haven't paid for them yet, they still record that expense. 

This approach helps businesses match their income and expenses to the correct time period, giving a more accurate picture of their financial situation, regardless of when the cash actually changes hands. 

How accrual accounting works? 

Accrual accounting is a method where transactions are recorded when they are incurred, rather than when cash changes hands. This means that revenue is recognized when goods or services are delivered, and expenses are recorded when they are incurred, regardless of when payment is made or received. This approach provides a clearer and more comprehensive view of a company’s financial position by aligning revenues with their related expenses. 

For example, if a business provides a service in December but doesn't receive payment until January, the revenue is recorded in December under the accrual method. Likewise, if the company incurs an expense in November but pays for it in December, the expense is recognized in November. 

Key features of accrual accounting

1. Matching principle: This principle ensures that revenues and related expenses are recorded in the same accounting period, providing an accurate reflection of profitability. For instance, if a business incurs costs in producing goods, those costs are matched with the revenue generated by selling those goods, even if payment occurs later. 

2. More accurate financial reporting: By recording all earned revenues and incurred expenses, accrual accounting offers a more accurate depiction of a company's financial health. This helps stakeholders make better financial decisions since they can assess current performance alongside future obligations and potential income. 

3. Compliance with accounting standards: Both the International Financial Reporting Standards (IFRS) and the Generally Accepted Accounting Principles (GAAP) promote accrual accounting. These guidelines ensure consistency and comparability of financial reports across businesses, making accrual accounting the preferred method for most companies, especially publicly traded ones. 

4. Impact on financial statements: Accrual accounting affects all major financial statements: 

• Income statement: Revenues and expenses are recognized when earned or incurred, not when cash is received or paid. 

• Balance sheet: Reflects accounts receivable (money owed to the company) and accounts payable (money the company owes) accurately. 

• Cash flow statement: Separates cash from operating activities from the accrual entries, giving a clearer picture of actual cash flow. 

Common adjusting entries explained 

Adjusting entries are made at the end of an accounting period to ensure that financial statements accurately reflect the company's financial position and performance. Here's a breakdown of the four common adjusting entries:  

1. Prepaid expenses 

Definition: Expenses paid in advance. 

Example: A company pays a yearly insurance premium in January. The entire amount is initially recorded as a prepaid expense. At the end of the year, a portion of the premium (representing the insurance used during the year) is expensed. 

Journal entry: 

Debit: Insurance Expense 

Credit: Prepaid Insurance 

2. Unearned revenue 

Definition: Revenue received in advance. 

Example: A customer pays for a subscription service for a year in advance. The entire amount is initially recorded as unearned revenue. As the customer uses the service, the revenue is recognized. 

Journal entry

Debit: Unearned Revenue 

Credit: Service Revenue 

3. Accrued expenses 

Definition: Expenses incurred but not yet paid. 

Example: Employees work during the last week of the month but are not paid until the following week. The wages earned during the last week are accrued as an expense at the end of the month. 

Journal entry

Debit: Wages Expense 

Credit: Wages Payable 

4. Accrued revenues 

Definition: Revenues earned but not yet received. 

Example: Interest is earned on a bank deposit but not yet paid. The interest earned is accrued as revenue at the end of the month. 

Journal entry 

Debit: Interest Receivable 

Credit: Interest Income  

Why are adjusting entries important? 

Adjusting entries ensure that financial statements are accurate and comply with accounting principles. They help to match expenses with the corresponding revenues and provide a clear picture of a company's financial health. 

Accrual accounting vs. Cash accounting 

Accrual Accounting and Cash Accounting are two primary methods used to record revenue and expenses. They differ in how they recognize income and costs.

Cash accounting 

• Recognition of revenue: Revenue is recognized when cash is received. 

• Recognition of expenses: Expenses are recognized when cash is paid. 

Example: A consulting company provides a $5,000 service to a client on Oct. 30. The client pays on Nov. 25. Under cash accounting, the revenue is recorded on Nov. 25 when the cash is received.  

Accrual accounting 

• Recognition of revenue: Revenue is recognized when it is earned, regardless of when the cash is received. 

• Recognition of expenses: Expenses are recognized when they are incurred, regardless of when the cash is paid. 

Example: Using the same consulting company example, under accrual accounting, the revenue would be recognized on Oct. 30 when the service is provided. Even though the cash isn't received until Nov. 25, the revenue is considered earned at the time of service. 

Double-entry accounting

Accrual accounting often uses double-entry accounting. This method requires every transaction to be recorded with a debit and a credit. 

For the consulting company: 

Choosing the right method  

The choice between accrual and cash accounting depends on various factors, including the size of the business, its industry, and regulatory requirements. Accrual accounting is generally preferred for larger businesses and financial reporting purposes, while cash accounting is often used by smaller businesses and for personal finance. 

Who should use accrual accounting? 

While accrual accounting is mandated for larger companies and publicly traded entities, small businesses or freelancers may opt for cash accounting. However, businesses with inventories or that extend credit to customers often find accrual accounting to be more beneficial, as it provides a complete view of financial obligations and incoming revenues. 

Why you need to outsource accounting services?

Outsourcing your accounting services can be a strategic move for your business, offering numerous benefits that enhance both efficiency and effectiveness. By partnering with experienced professionals, you gain access to a team of qualified experts who bring specialized knowledge and expertise to your financial management. Outsourcing can also lead to significant cost savings, as it is often more affordable than maintaining a full-time in-house accounting team. Additionally, outsourcing firms provide advanced cloud accounting services, allowing you to access your financial data remotely and securely from anywhere. Above all, privacy and data security are top priorities for these firms, ensuring that your sensitive financial information is protected. For businesses looking to streamline their operations and focus on growth, outsourcing accounting services with BookkeeperLive offers a valuable solution. 

FAQs 

1. When is accrual accounting mandatory? 

Larger businesses and publicly traded companies are generally required to use accrual accounting for financial reporting purposes. However, smaller businesses may have the option to use cash accounting. 

2. Can a small business use accrual accounting? 

Yes, small businesses can use accrual accounting. While it may be more complex than cash accounting, it can provide valuable insights into financial performance and help with decision-making. 

3. How does accrual accounting impact tax reporting? 

Accrual accounting can affect the timing of tax payments. For example, if a business recognizes revenue under accrual accounting but doesn't receive the cash until the following tax year, the revenue may be taxed in the earlier year. 

4. Can a business switch from cash accounting to accrual accounting? 

Yes, a business can switch from cash accounting to accrual accounting. However, this requires careful planning and may have tax implications. 

5. What are some common mistakes made in accrual accounting? 

Common mistakes include failing to make adjusting entries, improperly recognizing revenue or expenses, and not understanding the impact of accrual accounting on financial statements.