What is accrual accounting & how does it work?

When it comes to managing your business’s accounts, there are two main methods to choose from: accrual accounting and cash accounting.

While both methods have their benefits and drawbacks, accrual accounting can give you a better picture of overall business finances because it accounts for income and expenses as they occur, rather than simply looking at the funds in your bank account.

In this guide, we’re covering the basics of accrual accounting: what it is, benefits and drawbacks, how it compares to cash accounting and the main categories in accrual accounting.

What is accrual accounting?

Accrual accounting is a method of accounting where revenue and expenses are recorded in the order in which they occur rather than in the order in which they’re paid or received. 

In other words, revenue is recognised when it’s earned, and expenses are recognised when they are incurred, regardless of whether money has been transferred or withdrawn from your bank account. 

For example, let’s say a business invoices a customer for $500 on January 31 and the invoice is paid on March 5. With the accrual accounting method, the $500 would be recorded on the business’s books as revenue on January 31 rather than March 5.

Accrual accounting is most commonly used by medium and large businesses, although it can be used by small businesses as well. Some local tax agencies have rules around the types of businesses that can (or can’t) use accrual accounting, so if you’re not sure whether this method is right for you, it’s best to speak to a professional.

Accrual accounting vs cash accounting

As we’ve covered above, accrual accounting involves recording revenue as soon as it is invoiced, and recognising an expense as soon as a bill comes in. 

Cash accounting, on the other hand, only recognises revenue and expenses when the transaction has been settled. This means you can only update your books once an invoice has been paid by a customer, or once you’ve paid a bill. 

With cash accounting, you also only have to pay tax on money you’ve actually received rather than on invoices you’ve issued. This can be helpful for cash flow, but keep in mind that some tax agencies have rules around which businesses are allowed to use cash basis accounting for tax purposes.

Cash accounting tends to be the simplest accounting method because you only need to keep track of cash in and cash out, whereas with accrual accounting you have to stay on top of invoices and bills as well as your bank account. That said, accrual accounting can give you a more accurate picture of your true financial position and profitability.

Benefits of accrual accounting

• You get a more accurate picture of your business finances
• You can make business decisions with confidence, knowing where your finances stand
• You can see whether your business is profitable, rather than just your cash position
• It can be beneficial in applying for long-term business financing

Drawbacks of accrual accounting

• Can take more effort because you have to keep track of invoices and bills rather than just your bank balance
• You might have to pay tax on revenue before the customer has paid you

Categories in accrual accounting (with examples)

There are several types of accrual accounts that can be used depending on a business’s activities. However, all accrual accounts fall into one of two categories: revenues (receivables) or expenses (payables).

Revenues (receivables)

Accrued revenues include income from generated invoices and assets that are yet to be received.

Examples:

• A landlord recording a tenant's rent payment at the first of the month even though they will receive the rent at the end of the month
• A construction company recording a portion of revenue for a year-long contract in each month as services are delivered, rather than waiting until the end of the contract
• A loan company recording interest income every month even if the customer’s loan repayments are made quarterly or annually.

Expenses (payables)

Accrued expenses include any costs that a business is obligated to pay but are yet to be settled.

Examples:

• A travel agency recording a $500 utilities bill as an expense when it’s received in January, even though payment isn’t due until March
• A construction company recording wages owed to employees that have yet to be paid
• A cafe recording a rent bill when it’s received at the first of the month even though they will pay the rent at the end of the month

Managing your finances with accrual accounting

While accrual accounting can be more involved than cash accounting, it can also give you a more realistic long-term overview of your finances and help you make decisions with confidence. 

Whether the accrual method or cash method is most suitable for your business, QuickBooks’ accounting software makes it easy to keep your accounts organised and update income and expenses from anywhere, on any device. You can also switch between cash accounting and accrual accounting whenever you need to.