What is accrual accounting? A beginners guide

Has your business reached the point where you’re ready to hire more employees or expand into new customer markets? As your business becomes more complex, it may be time to revisit whether accrual accounting will be more effective for your financial and tax reporting.

In this post, we’ll go over what you need to know about the accrual method of accounting, including its benefits, how it compares to cash accounting, and if it’s right for your business. 

The differences between cash vs. accrual accounting

Though people commonly confuse accrual accounting with cash accounting, there are some stark differences to know before choosing which is right for your business. 

Accrual-based accounting is a popular method for big companies, as it uses the double-entry accounting method, which is more accurate and conforms with the generally accepted accounting principles (GAAP).

In accrual accounting, you record income and expenses as you earn or incur them. This means you add income to your accounting journal when you complete a service or deliver goods and expenses when you receive an invoice for the goods and services.

Cash accounting, on the other hand, records income and expenses when you receive or deliver payment for goods and services. Most small businesses prefer the cash method because it’s simpler.

Here’s how they work: Let’s say your business provided a service to a customer in June, but they’ll only pay you in July. With accrual accounting, you’d record income for June, which is when you performed the service. But with cash accounting, you’d record income in July, when you received the payment. 

Most businesses can choose between cash and accrual accounting methods. However, if an inventory is necessary to account for your income or your company’s income is over $25 million, the IRS will require you to use the accrual method.

How accrual accounting works for different adjusting entries

When using accrual accounting, you’ll have different adjusting entries to add to the balance sheet and income statement. 

These entries divide into two categories:

• Accruals: Revenue and expenses you haven’t yet received or paid, but you already provided the good or service.  
• Deferrals: Revenue and expenses you received or paid before providing or receiving the goods and services. 

Let’s take a look at these types of adjusting entries and how you can use them in accrual accounting.

Accrued revenue

Accrued revenue is any income you expect to receive for any good or service you provided. It essentially means a customer owes you money for the transaction. 

For example, if you provided a consulting service for $100 in January but you expect the customer to pay in February, you’ll have an accrued revenue of $100 in January. 

In this case, you'd debit your accounts receivable and credit revenue. Here’s how you’d record this in January:

Then, in February, when you receive the payment, you’ll credit accounts receivable, which means receivables go down, and debits cash, which will go up.

Deferred revenue

Differently than accrued revenue, deferred revenues happen when a customer has paid for a good or service you haven’t yet provided. Meaning you owe the customer what they paid for. 

This is common when customers pay for a subscription or have recurring payments, like a phone bill. For example, let’s say a customer paid $100 for your consulting services in January, but you’ll only be providing the service in February. 

In this case, you would debit your cash account since it increased, and you'd credit your deferred revenue, which is a liability account. Here’s how you’d record this in January:

When you provide the consulting service in February, you’ll debit your deferred revenue, decreasing your liability. Then, you’ll credit revenue like so:

Accrued expenses

Accrued expenses are similar to accrued revenues in the sense that you were recording when the transaction happened, and not when there’s a payment. But in this case, your business is the one that has to pay. 

This happens when you receive a good or service, but the provider expects you to pay at a later date. For example, let’s say you received merchandise for your business in March and received an invoice of $500 with payment due in April. 

In accrual accounting, you’d record when you received the merchandise. In March, you’d debit $500 for expenses and credit accounts payable since you still have to pay for it. Here’s what it would look like:

Once you pay for the merchandise in April, you’ll debit accounts payable and credit cash:

Prepaid expenses

Prepaid expenses are the opposite of accrued expenses. This means you already paid for the goods or services that you’re yet to receive. In this case, someone still owes you the goods and services you paid for. 

For example, if you paid $500 for merchandise from your supplier in March, but they’ll only deliver them in April, you’ll have to debit the prepaid expense account and credit your cash account:

After you receive the merchandise in April, you’ll debit your expense account and credit prepaid expense:

Advantages of accrual accounting

Recording cash transactions based on when you complete services, deliver products, and incur expenses is also beneficial to your business.

Here are the main advantages typically associated with accrual accounting.

• Provides a more accurate view of your business’s performance: Since you can measure profitability and business activity during a specific month or year. 
• Makes it easier to track revenue if you sell on credit: Since you record the transactions when they happen instead of after payment. 
• Can defer your tax liability: Since you can delay paying taxes on a certain income if a customer pays the year after it was delivered. 

Still, it’s important to review the IRS guidelines on how to report an advance payment for services using the accrual accounting method.

Disadvantages of accrual accounting

Whereas accrual accounting’s strengths lie in accurately showing business profitability and representing long-term revenues and expenses, it has a few drawbacks as well.

Here are some pitfalls of accrual accounting:

• Does a poor job of tracking cash flows: Since your bank account may show a smaller balance than your income statement if customers haven’t paid what they owe you.
• Requires more bookkeeping and staff resources: Since you need to track cash flow separately to cover your bills which can be more complicated and expensive to implement.

Due to the added complexity and paperwork required under the accrual method of accounting, small business owners—particularly when starting a business—tend to view it as a less ideal option than the cash accounting method.

Streamline your accounting and save time

Accrual accounting provides a better picture of your overall financial position, and many companies consider it to be the standard and more accurate accounting method. But it can also be too complicated and expensive for small business owners. 

One way to offset the people and time resources required under accrual accounting is to invest in accounting software that does the hard work for you.

Accrual accounting FAQ

Still have questions about accrual accounting? We’ve got the answers. 

What is an accrual in simple terms?

Accrual accounting is when you recognize a transaction in your journal entry when it happens instead of when you receive payment. 

What is the basic rule for accrual accounting?

The basic rule of accrual accounting is to record transactions when they happen instead of when you receive or deliver payment. 

What are the three accounting methods?

The three accounting methods are cash basis accounting, accrual accounting and modified cash basis accounting, which combines cash and accrual accounting.