The accrual accounting method records revenues and expenses when they are earned or incurred, regardless of when cash transactions occur. In contrast, cash accounting records transactions only when cash is exchanged.

Accrual accounting recognizes revenues when they are realized—typically when goods are delivered or services are performed—even if payment has not yet been received. It also recognizes expenses when they are incurred, not necessarily when they are paid. This method matches revenues to the expenses incurred to generate them within the same reporting period. As a result, accrual accounting more accurately shows a company’s financial health and operational performance.

US businesses with $25 million or more in revenue over a three-year period must use accrual accounting, but some smaller businesses use it, too. Below, we’ll cover the different types of accruals, how accrual accounting works, its advantages and challenges, and best practices.

What’s in this article?

• Types of accounting methods
  
• Accrual accounting vs. cash accounting
  
• How does accrual accounting work?
  
• Types of accruals
  
• Accrual accounting advantages
  
• Accrual accounting challenges
  
• Accrual accounting best practices
  

Types of accounting methods

Businesses use three primary accounting methods to record financial transactions: accrual, cash, and hybrid accounting. Here’s an overview of each method and its rules for recording revenues and expenses.

• Accrual accounting: Accrual accounting records income and expenses when they are earned or incurred, regardless of when cash transactions occur. This method more accurately shows a company’s financial position and performance, making it suitable for larger businesses or those that handle credit transactions.

• Cash accounting: Cash accounting records transactions only when cash changes hands. This ensures revenues are recognized when they’re received and expenses are recognized when they’re paid. Small businesses and individuals often use this method, because it clarifies how much cash the business has at any given time.

• Hybrid accounting: Hybrid accounting combines elements of both accrual and cash accounting. It allows businesses to use cash accounting for most transactions but switch to accrual accounting for major items. This flexibility can benefit small businesses that have to simplify day-to-day transactions but need accrual accounting to accurately report large amounts of receivables, payables, or inventory. Businesses must carefully manage hybrid accounting to comply with tax laws and accounting standards.

Accrual accounting vs. cash accounting

Consider the type of business you run as you choose your accounting method. Larger businesses with complicated accounting needs generally prefer accrual accounting, while smaller, cash-based businesses and individuals might choose cash accounting for its simplicity. Public companies or those with substantial revenue typically use accrual accounting to comply with legal and regulatory standards.

Here are the pros and cons of accrual and cash accounting.

Accrual accounting

Accrual accounting records income when it is earned and expenses when they are incurred, regardless of when money is received or paid.

Pros

• It more accurately reflects a business’s financial status by matching revenues earned with the expenses incurred to generate those revenues.

• It makes financial planning and analysis easier by aligning business activity with financial outcomes.

• Generally accepted accounting principles (GAAP) in the US and International Financial Reporting Standards (IFRS) worldwide usually require or encourage larger or publicly traded businesses to use it for consistent and comparable financial reporting.

Cons

• Because it tracks receivables and payables, it’s harder to implement and maintain.

• It does not provide a direct indication of cash flow, which can be misleading for cash-sensitive businesses.

Cash accounting

Cash accounting records revenues when cash is received and expenses when cash is paid out.

Pros

• Tracking straightforward cash transactions is easier to manage than accrual accounting.

• Cash-centric businesses or those with straightforward financial structures benefit from knowing the amount of available cash.

• It can simplify a business’s taxes, since income is not taxed until it is received and expenses are not recorded until they are paid.

Cons

• It might not accurately show long-term financial health, because it does not account for future obligations or receivables.

• It provides less insight into a business’s overall profitability over time, because it can misrepresent the results of financial activity based on cash flow timing.

How does accrual accounting work?

The accrual accounting method records revenues and expenses when they are earned or incurred, regardless of when cash is received or paid. In contrast, cash accounting records transactions only when money changes hands.

Here’s how accrual accounting works.

Revenue recognition

A company considers revenue earned once it delivers goods or services to a customer, fulfilling its obligations under a contract or agreement.

That revenue becomes realizable when the company can expect payment for the goods or services.

Once revenue is both earned and realizable, the company records it on the income statement, even if it hasn’t received the cash payment yet. The business also creates an accounts receivable entry to track the amount owed by the customer.

Expense recognition

A company considers an expense incurred once it receives goods or services from a supplier or employee, compelling the company to pay for them.

The business then records the incurred expense on the income statement, even if it hasn’t paid for the expense yet. The business creates an accounts payable entry to track the amount owed to the supplier or employee.

Matching principle

Accrual accounting follows the matching principle, which matches expenses with corresponding revenues in the same reporting period. By this principle, a company should recognize the expenses incurred to generate revenue in the same period as the revenue itself.

For example, say a company sells goods to a customer in December but doesn’t receive payment until January of the following year. Under accrual accounting, the company recognizes revenue in December when it’s earned, even though it hasn’t received the cash payment yet. It creates an accounts receivable entry to track the amount owed. When the company receives cash payment in January, it reduces the accounts receivable and increases the cash account.

Types of accruals

There are two types of accruals in accounting: accrued revenues and accrued expenses. These accruals are a key part of the period-end closing process in accrual accounting. They ensure that financial statements reflect all revenues earned and expenses incurred during a specific period, in line with the matching principle of accounting.

• Accrued revenues: Accrued revenues, also known as accrued assets, are revenues that have been earned but not yet received in cash. This often happens when a business provides services but hasn’t yet issued the invoice or received payment. For example, a company that provided consulting services at the end of a month but will not bill the client until the following month needs to recognize the revenue earned in the accrual accounting period.

• Accrued expenses: Accrued expenses, also known as accrued liabilities, are expenses that have been incurred but not yet paid or recorded in the accounts. For example, companies often pay employees’ salaries the month after they are earned. They must record these expenses in the month when they used the employees’ services.

Accrual accounting advantages

Accrual accounting more accurately represents a company’s financial position by recording revenues and expenses when they occur, rather than when cash is exchanged. Here’s how businesses can benefit from improved accuracy:

• Financial insight: By matching expenses with the revenues they generate, accrual accounting gives insight into true costs and profitability. This helps with budgeting, forecasting, and strategic planning. Businesses can then analyze performance without the inaccuracies caused by timing differences in cash flows.

• Long-term contract management: For businesses that handle long-term contracts, accrual accounting keeps revenues and expenses aligned with the related contractual obligations. This helps businesses track each project’s financial progress more accurately.

• Credit transaction tracking: Businesses that operate on credit—offering or receiving goods and services before cash changes hands—can track receivables and payables more effectively with accrual accounting. This helps them manage cash flow forecasts and assess the liquidity needed to support operations.

• Budget control: With the ability to match expenses directly to revenues, businesses can analyze which areas are over or under budget and adjust their tactics accordingly. This leads to more controlled and strategic allocation of resources.

• Stakeholder analysis: Investors, creditors, and other stakeholders rely on accurate financial statements to make informed decisions. Accrual accounting shows a company’s operational effectiveness and financial stability more clearly to stakeholders.

Accrual accounting challenges

While accrual accounting offers many advantages, it also presents the following difficulties:

• Implementation: Accrual accounting requires businesses to track receivables, payables, and other financial events that do not involve immediate cash transactions—complicating the accounting process. Strong systems and policies must be in place to accurately record and match revenues and expenses.

• Personnel: Companies will need skilled accountants who understand accounting principles and can accurately record and analyze financial data. This might require additional training and higher staffing costs.

• Cost: Implementing and maintaining an accrual accounting system can be more expensive than using a simple cash accounting system. These costs include more sophisticated accounting software and potentially increased expenses for auditing and compliance.

• Cash flow management: Since accrual accounting focuses on earned revenues and incurred expenses rather than cash flows, it can misrepresent cash availability. Businesses must carefully manage their cash flows separately from accrual accounting to ensure they have sufficient liquidity for day-to-day operations.

• Estimation and judgment: Accrual accounting often involves making estimates and judgments, such as allowances for doubtful accounts (accounts receivable that could go unpaid and become losses), depreciation methods, and accrued expenses such as taxes and bonuses. These estimates can introduce errors and biases into financial statements.

• Compliance: Accrual accounting’s complexity increases the risk of errors in financial statements, which can lead to audit findings and compliance issues.

• Reconciliation: Businesses using accrual accounting must regularly reconcile accounts receivable, accounts payable, and accrued expenses. These reconciliations can be time-consuming and require attention to detail to correct discrepancies.

• Manipulation: Fraudulent actors might manipulate accrual accounting’s flexibility in timing and estimation to present a more favorable financial picture. This can lead to earnings mismanagement or even fraudulent reporting.

Accrual accounting best practices

Here are some best practices for implementing accrual accounting at your business.

Revenue recognition

• If your business uses a subscription-based model, carefully assess the timing of revenue recognition. You could recognize revenue during the subscription period or at specific milestones based on the transfer of control over goods or services.

• Thoroughly analyze contracts to identify distinct performance obligations and allocate the transaction price accordingly, so you can properly recognize revenue for bundled products or services.

• Accurately estimate variable considerations (e.g., bonuses, incentives) and adjust revenue recognition based on the probability of earning or not earning them.

Expense recognition

• Standardize processes for accruing recurring expenses such as rent, utilities, and salaries to reduce errors and ensure timely recognition.

• Establish procedures for assessing contingent liabilities (e.g., potential lawsuits, warranty claims). Accrue for probable liabilities and disclose potential liabilities in the footnotes of financial statements.

• Regularly refine estimates for accruals such as bad debts (outstanding balances that must be written off) and warranty expenses. Integrate historical data and current trends for greater accuracy.

Internal processes

• Separate the responsibilities for authorizing transactions, recording them, and reconciling accounts. This reduces the risk of errors and fraud.

• Regularly review accrual accounting processes, including estimates and journal entries, to correct errors.

• Keep detailed documentation of all accrual accounting policies, procedures, and calculations for transparency and audits.

• Use accounting software with strong accrual accounting capabilities to automate calculations, track accruals, and generate accurate reports.

• Use data analytics to analyze trends in revenue and expenses, identify anomalies, and improve forecasting accuracy.