Gone are the days when organizations paid cash for the goods and services they needed. More often than not, companies (and individuals) prepay or pay later for goods and services. So, how do organizations keep track of these non-cash transactions?
The form of financial accounting that allows companies to keep up with these more complicated transactions is called accrual accounting. As a result, more companies are looking for highly skilled financial accounting professionals, well-versed in this method. Here’s an overview of the accrual accounting method and why so many organizations rely on it.
What Is Accrual Accounting and Why Is It Important?
Accrual accounting is an accounting method that recognizes revenue in the period in which it’s earned and realizable, but not necessarily when the cash is actually received. Similarly, expenses are recognized in the period in which the related revenue is recognized rather than when the related cash is paid.
The accrual method of accounting is based on the matching principle, which states that all revenue and expenses must be reported in the same period and “matched” to determine profits and losses for the period. It’s often compared against cash accounting.
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Accrual Accounting vs. Cash Accounting
While accrual accounting is the most widely used accounting method, some businesses prefer to use cash basis accounting. Cash accounting is an accounting method in which revenue is only recorded when cash is received, and expenses are recorded after cash payments are made.
The main difference between accrual and cash accounting is when transactions are recorded. Accrual accounting recognizes income and expenses as soon as the transactions occur, whereas cash accounting does not recognize these transactions until money changes hands.
Cash accounting is the easier of the two methods, as organizations only need to record transactions when cash is exchanged. For most companies, however, this method doesn’t provide an accurate view of financial health.
The Advantages of Accrual Accounting
Although it’s the more complex of the two major accounting methods, accrual accounting is considered the standard accounting practice for most organizations. Using accrual accounting, companies look at both current and expected cash flows, which provides a more accurate snapshot of their financial health.
Accrual accounting is helpful because it shows underlying business transactions, not just those with cash involved. Most transactions a company has are straightforward, with payment happening at the time of the transaction. Other, more complicated transactions involve buying and selling on credit, which requires a company to account for monies that they will have to pay or receive at a future date.
Even more complicated are transactions that require paying for goods or services or receiving money from customers in advance. The timing of when revenues and expenses are recognized related to these more complicated transactions can have a major effect on the perceived financial performance of a company.
Types of Accruals
The revenues a company has not yet received payment for and expenses companies have not yet paid are called accruals. Here are the four types of accruals typically recorded on the balance sheet when following the accrual accounting method.
1. Deferred Revenue
When a company receives cash before a good has been delivered or a service has been provided, it creates an account called deferred revenue, also referred to as unearned revenue. This account is a liability because the company has an obligation to deliver the good or provide the service in the future.
Suppose you paid a gym $1,200 for a year-long membership ($100 per month). Using the accrual accounting method, the gym would set up a deferred revenue account (a liability) for the $1,200 to show that it had received the cash but not yet provided the service.
As each month of the year passes, the gym can reduce the deferred revenue account by $100 to show it's provided one month of service. It can simultaneously record revenue of $100 each month to show that the revenue has officially been earned through providing the service.
2. Accrued Revenue
Accrued revenue occurs when a company has delivered a good or provided a service but hasn’t yet received payment. These accounts are often seen in the cases of long-term projects, milestones, and loans.
For example, let’s say that a clothing retailer rents out a storefront for $2,500 per month, paying each month’s rent on the first day of the following month. This means that the landlord doesn’t receive payment until after services have been provided. Using the accrual accounting method, the landlord would set up an accrued revenue receivable account (an asset) for the $2,500 to show that they have provided services but haven’t yet received payment.
3. Prepaid Expenses
When a company pays cash for a good before it is received, or for a service before it has been provided, it creates an account called prepaid expense. This account is an asset account because it shows that the company is entitled to receive a good or a service in the future.
For example, imagine a dental office buys a year-long magazine subscription for $144 ($12 per month) so patients have something to read while they wait for appointments. At the time of the payment, the dental office sets up a prepaid expense account for $144 to show it has not yet received the goods, but it has already paid the cash.
As each month of the year passes, the dental office can reduce the prepaid expense account by $12 to show it has ‘used up’ one month of its prepaid expense (asset). It can simultaneously record an expense of $12 each month to show that the expense has officially incurred through receiving the magazine.
4. Accrued Expenses
Accrued expenses, also known as accrued liabilities, occur when a company incurs an expense it hasn't yet been billed for. Essentially, the company received a good or service that it will pay for in the future. In the meantime, the expense is an accrued liability.
Suppose a company relies on a utility, like an internet connection, to conduct business throughout the month of January. However, it pays for this utility quarterly and will not receive its bill until the end of March. Even though it can’t pay for it until March, the company is still incurring the expense for the entire month of January. The expected cost of internet for the month will need to be recorded as an accrued expense at the end of January.
Choosing the Right Accounting Method
While cash accounting is a viable option and often a good fit for smaller businesses, accrual accounting generally provides a more comprehensive view of a company’s financial health. Following this method of accounting, you can prepare more accurate financial statements that can be used to inform strategic decisions at your organization.
Do you want to develop or hone your financial accounting skills? Explore our eight-week online course Financial Accounting and other finance and accounting courses to discover how managers, analysts, and entrepreneurs leverage accounting to drive strategic decision-making.
This post was updated on July 12, 2021. It was originally published on September 29, 2016.