What is Accrual Accounting?
Reading Time: 3 minutesWhat is accrual accounting? What small business does this method fit? Can your company apply it? What is the IRS’s take?
This article will answer these and other questions.
Before going into details, here’s an everyday hypothetical example of accrual accounting.
Let’s say a friend promises you a gift. You appreciate the gesture, express excitement, and thank them before receiving it. However, the gift doesn’t come immediately.
That defines how accrual accounting works.
So,
What is accrual accounting?
It is an accounting system where you record earned revenue or expenses before cash payment occurs.
The earned revenue before cash payment for goods or services is known as accrued revenue.
Similarly, when a company purchases items from vendors on credit and records the transaction before cash exchange occurs, it is an accrued expense or liability.
Accruals impact a company’s net income, income statement, and balance sheet, as they involve non-cash assets and liabilities.
Let’s look at an example.
What is an example of accrual?
Home gas service providers are examples of the accrual accounting model.
Customers use the gas services daily and only make payments at the end of the month or on an agreed billing period.
Although the company records an earned revenue by providing its gas service to consumers, payment comes at the end of the month.
When cash transactions occur at the end of the month, accounts receivable reduce while the cash account increases.
For expenses, if you purchase an item for $3,000 on credit, the transaction goes into the accounts payable record before payment occurs.
Generally, it helps a company track its financial position more accurately.
What are the types of accruals?
There are various types of accrual in accounting, such as accounts payable, accounts receivable, goodwill, accrued interest earned, and accrued tax liabilities. However, they all fall under two common types.
- Expense accruals
- Revenue accruals
Expense accruals
These are debt obligations a business will pay for later.
The accrual principle allows you to record expenses incurred without the outflow of cash and adjust them at a later date.
Revenue accruals
These are records of receivables on your balance sheet for which payment will come later.
When you receive the cash later, receivables will reduce as cash increases.
What is the purpose of accrual in accounting?
It gives a company a more comprehensive picture of its financial state because it captures all transactions, including accounts receivable, accounts payable, employee salaries, etc.
Unlike cash-basis accounting, it provides an overview of upcoming income and expenses within an accounting period.
We’ll look at the advantages and disadvantages of accrual basis accounting.
Advantages
- It shows a more accurate view of a business’s long-term financial state. Since the company records revenues and expenses immediately, it can analyze trends and manage finances over time.
- It’s easier to match revenues with expenses.
- It helps with business planning. You will be able to create budgets for your expenses and predict sales.
- It is compliant with GAAP.
Disadvantages
- To comply with GAAP, rules that guide the recognition of revenue and expenses in accrual basis accounting could be complicated. It is best to seek the help of experts.
- It could be deceptive to indicate a business is profitable even though the expected cash inflows are not received. A company could risk going bankrupt while the books in the accrual records tell otherwise.
Does the IRS require accrual accounting?
The IRS does not require a single method of accounting for all businesses.
If your company has average annual gross revenue greater than $25 million or it’s publicly traded, you require the accrual method and cannot use the cash method.
Final thoughts
Accrual accounting shows more balanced records for business analysis; however, it doesn’t apply to every business.
The accrual method may not be suitable if your business deals primarily in cash for revenue and expenses.
On the other hand, if your business extends a lot of credit to customers or uses credit with suppliers—accrual accounting would be the best choice for recording financial transactions.
With online accounting software like Akaunting, you can easily track and manage your accounts receivable and accounts payable.
You can automate and simplify the accrual accounting process and minimize errors with features like a journal entry, general ledger, and trial balance.
Accrual Accounting Frequently Asked Questions (FAQs)
- What is the difference between accrual and cash accounting
Accrual accounting recognizes revenue when the customer gets the goods or services. While Cash accounting recognizes transactions only when there is an exchange of cash.
- What is the best accounting method for a small business?
Cash basis is the most common accounting method used by small businesses.
- What type of accounting does the IRS use?
The most commonly used accounting methods are the cash and accrual methods. Under the cash method, you generally report income in the tax year you receive it and deduct expenses in the tax year you pay it.
- Accrued expenses vs. accounts payable
Accrued expenses are payment obligations that build up over time. The amount isn’t fixed. In contrast, Accounts payable are liabilities with a fixed amount and a future payment obligation.
