Accrual Accounting: Definition, Types, Benefits, And Example

Accrual Accounting: What if your business earned revenue today but didn’t receive the cash until next month? How would you record it?

This is where accrual accounting comes in. It’s a method that records revenues and expenses when they are earned or incurred, not when cash is exchanged. This approach gives a clearer picture of a company’s financial health, unlike cash accounting, which records transactions only when payments are made or received.

Here, we’ll cover the accrual accounting definition, explain what is the accrual method of accounting, how does accrual accounting works, its types, benefits, and compare it with cash accounting. Understanding the accrual basis of accounting is crucial for accurate financial reporting.

What is Accrual Accounting?

Accrual accounting is a method where revenues and expenses are recorded when they are earned or incurred, not when cash is received or paid. This approach follows the accrual basis of accounting, ensuring that financial transactions reflect the actual period they occur.

For example, if a company provides services in December but gets paid in January, the revenue is recorded in December. Similarly, expenses are recorded when incurred, even if payment happens later.

The accrual concept in accounting relies on the matching principle, aligning revenues with related expenses to give an accurate financial picture. This is the foundation of the accrual method of accounting.

How Does Accrual Accounting Work?

Accrual accounting records revenues and expenses when they are earned or incurred, not when cash is received or paid. This approach follows the accrual basis of accounting, ensuring financial records reflect actual business activity.

Steps in Accrual Accounting

Here’s a step-by-step guide on how accrual accounting works:

Step 1: Identifying Transactions

The first step in accrual accounting is to identify all financial transactions within an accounting period. This includes revenue earned and expenses incurred, even if no cash has been exchanged yet.

Step 2: Categorizing Transactions

Once identified, transactions are categorized into:

Accruals: Revenues and expenses recognized before cash is received or paid (e.g., accounts receivable, accounts payable).
Deferrals: Cash received or paid before the revenue is earned or the expense is incurred (e.g., prepaid expenses, deferred revenue).

Step 3: Making Adjusting Entries

Adjusting entries ensures financial records are accurate. This involves:

Accounts Receivable (Asset): Revenue earned but not yet paid.
Accounts Payable (Liability): Expenses incurred but not yet paid.
Deferred Revenue (Liability): Cash received for services/products not yet delivered.
Prepaid Expenses (Asset): Payments made for future expenses.

Step 4: Applying the Matching Principle

Accrual accounting follows the matching principle, meaning revenues and related expenses are recorded in the same period to reflect accurate profits.

For example, if a company provides services in December but gets paid in January, revenue is recorded in December, and cash is updated in January.

Step 5: Preparing Financial Statements

After adjustments, financial statements like the income statement, balance sheet, and cash flow statement are prepared, reflecting accurate financial data.

Step 6: Closing the Books

At the end of the period, temporary accounts (e.g., revenue and expenses) are closed, and the net income or loss is transferred to retained earnings, preparing the books for the next accounting cycle.

Accrual Accounting Example

Accrual accounting records transactions when they occur, regardless of when the cash is exchanged. Here’s a simple example to understand how it works:

Example: Software Development Company

Let’s assume you run a software development company. You complete a project for a client in December 2024, worth Rs10,000. You send an invoice on December 31, but the client doesn’t make the payment until January 15, 2025.

Under accrual accounting, you would record the revenue in December 2024 when the service was provided and earned, even though payment hasn’t been received yet. This ensures your financial statements accurately reflect the work completed in that period.

Journal Entries for December 2024:

Account	Debit (₹)	Credit (₹)
Accounts Receivable	10,000
Revenue		10,000

In January 2025, when the payment is received, the company will adjust the cash account and reduce accounts receivable.

Journal Entries for January 2025:

Account	Debit (₹)	Credit (₹)
Cash	10,000
Accounts Receivable		10,000

Also Read: Double Entry Accounting

This example illustrates how accrual accounting recognizes revenue when it is earned, not when the cash is received. It ensures a more accurate picture of the company’s financial performance.

Types of Accrual Accounting

In accrual accounting, businesses record revenues and expenses when they are earned or incurred, not when the cash is exchanged. The method involves four main types of accruals: deferred revenue, accrued revenue, prepaid expenses, and accrued expenses. Let’s explore each type in detail.

1. Deferred Revenue:

Deferred revenue refers to money a company receives before delivering goods or services. Since the company still has an obligation to fulfill, this revenue is recorded as a liability on the balance sheet. The revenue is only recognized once the service or product is provided.

Recognized when goods/services are provided.
Initially recorded as a liability (deferred revenue).
Adjusted monthly as services are delivered.

For example, a gym gets $1,200 upfront for a yearly membership, recording $100 as monthly revenue and the rest as deferred revenue.

2. Accrued Revenue:

Accrued revenue occurs when a company has delivered goods or services but has not yet received payment. The revenue is recognized even though payment is still pending, making it an asset until the company receives the money.

Recognized when goods/services are provided.
Recorded as an asset (accrued revenue) until payment is received.
Common in long-term projects or contracts.

For example, a software company finishes a project but gets paid the next month, recording the revenue as accrued revenue now.

3. Prepaid Expenses:

Prepaid expenses arise when a company makes a payment for goods or services before they are received. These payments are considered assets, as the company will benefit from the goods or services in the future.

Recognized when cash is paid, but goods or services will be received later.
Recorded as an asset (prepaid expense).
These expenses are recognized gradually over time as the benefit is utilized.

For instance, a business pays $1,200 for a year-long insurance policy, recording it as a prepaid expense and recognizing $100 as an expense monthly.

4. Accrued Expenses (Accrued Liabilities):

Accrued expenses are costs a company incurs for goods or services it has received but has not yet paid for. These expenses are recorded as liabilities until they are paid.

Recognized when the service or goods are received.
Recorded as liabilities (accrued expenses).
Paid later, after the service has been used.

For example, a company receives utility services for the month of January but will pay for them in February. The company records the utility cost as an accrued expense in January, even though the payment is due later.

Also Read: What are Accounting Policies and How are they Used?

By using accrual accounting, businesses ensure their financial records reflect all earned revenues and incurred expenses for a given period, offering a more accurate view of their financial health.

Benefits of Accrual Accounting

Accrual accounting offers a clearer picture of a company’s financial health by recording revenues and expenses when they occur, not when cash changes hands. Here are the main benefits:

Accurate Financial Reporting: Accrual accounting provides a true representation of financial health by matching revenue with expenses in the same period, ensuring accurate financial statements.
Better Decision-Making: The accrual basis of accounting offers valuable insights into current and expected cash flows, helping businesses make informed decisions and allocate resources effectively.
Transparent Operations: With accrual accounting, businesses can track expenses and liabilities as they occur, providing transparency to stakeholders and enhancing financial clarity.
Improved Long-Term Planning: This method is ideal for businesses with long-term contracts, aligning revenues and expenses with related obligations, which improves financial tracking.
Compliance with Standards: Accrual accounting ensures adherence to GAAP, making it a requirement for audits and financial reporting in many organizations.
Better Cash Flow Management: Accrual accounting helps manage both current and future cash flows, enabling businesses to plan and manage liquidity more effectively.

However, accrual accounting provides an accurate, transparent, and reliable overview of a company’s finances, improving decision-making and long-term planning.

Difference Between Accrual Accounting and Cash Accounting

Accrual accounting and cash accounting are two common methods businesses use to record financial transactions. The primary difference lies in when transactions are recorded in the financial statements. Here’s a quick overview of both methods and their differences:

Accrual Accounting vs. Cash Accounting: Key Differences
Feature	Accrual Accounting	Cash Accounting
Revenue Recognition	Records revenue when earned, regardless of cash receipt	Records revenue only when cash is received
Expense Recognition	Records expenses when incurred, even if cash hasn’t been paid yet	Records expenses when cash is paid
Compliance	Required by GAAP for larger businesses or public companies	Not accepted by GAAP, mostly used by smaller businesses
Complexity	More complex, requires tracking receivables and payables	Simpler, only tracks cash flows
Accuracy of Financials	Provides a more accurate financial picture, including future transactions	Provides a less complete view of financial health
Suitability	Best for larger businesses with complex transactions	Ideal for small businesses with simple transactions

Also Check: Cost Accounting vs Financial Accounting

Furthermore, Accrual accounting offers a more accurate view of financial health by recognizing revenues and expenses when they occur. It’s ideal for complex businesses but requires more effort. To study it, focus on core concepts like revenue recognition, accounts receivable, and the matching principle, and practice preparing financial statements to build your skills.

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Accrual Accounting FAQs

What is accrual accounting?

Accrual accounting is a method where transactions are recorded when they occur, rather than when cash is received or paid. It ensures that revenues and expenses are recorded in the period when they are earned or incurred.

How does accrual accounting work?

Accrual accounting works by recognizing revenue when it's earned, and expenses when they are incurred, regardless of when cash changes hands. This method offers a clearer view of a company's financial health.

What are the key principles of accrual accounting?

The two main principles of accrual accounting are the matching principle, which ensures expenses are recorded in the same period as the related revenue, and the revenue recognition principle, which records revenue when earned, not when received.

How do journal entries work for accruals?

In accrual accounting, the journal entry for accrued expenses involves debiting the expense account and crediting accounts payable. This reflects the incurred expenses that have not yet been paid, increasing both expenses and liabilities.

What is the difference between accrual accounting and cash accounting?

The main difference between accrual accounting and cash accounting is timing. In accrual accounting, transactions are recorded when they occur, while in cash accounting, they are only recorded when cash is exchanged. Accrual accounting offers a more accurate view of financial performance.