What is Accrual Accounting?
Accrual accounting is an accounting method that records revenue and expenses when a transaction is made, instead of when payment is received. It is based off of the Generally Accepted Accounting Principles (GAAP) and follows the matching principle, which states that revenues and expenses should be accounted for in the same period.
This guide explains accrual accounting basics, including:
- a definition of what accrual accounting is
- the underlying GAAP accounting principles
- the accrual accounting method vs. cash basis accounting method
- an accrual based accounting example
- how to calculate accruals
GAAP Principles of Accrual Accounting
The accrual method is required by generally accepted accounting principles (GAAP) because it more accurately presents financial results than a cash-basis accounting method. Accrual accounting principles require accounting that uses the date the obligation or transaction occurs, even if cash hasn’t yet been paid or received.
Besides recording and recognizing revenue and related expenses in the same accounting period using the matching principle and revenue recognition rules, other GAAP accounting standards apply to accrual-basis accounting.
As an example, loss contingencies must be accrued before the financial statements are issued for the accounting period, if it’s (1) probable that a loss or asset impairment will be incurred upon the occurrence of a future event and (2) the amount can be reasonably estimated (ASC 450-20-25-2).
If other GAAP rules exist in the FASB’s Accounting Standards Codification (ASC) for specific types of loss contingencies and recoveries, then those GAAP accounting methods would apply instead. Other GAAP accounting standards to consider are listed in the linked Deloitte Roadmap Series: A Roadmap to Accounting for Contingencies and Loss Recoveries report.
GAAP Methods for Recording Transactions
Accrued Revenue vs. Deferred Revenue
As you discover how accrual based accounting applies to revenue, know what the difference is between accrued revenue and deferred revenue.
Accrued revenue is earned before cash is received. Following revenue recognition rules, revenue is recorded when earned as a credit to Sales or another Revenue account summarized in the income statement and a debit to the current asset balance sheet account called Accounts Receivable. Later, when cash is received, Accounts Receivable is credited, and Cash is debited.
Deferred revenue (also called unearned revenue) is recorded in a liability account when an advance cash payment is received from a customer before the revenue is earned. The liability means a contractual obligation to perform has not yet been fulfilled. The product has not been shipped, or the service has not been performed. The accounting transaction is to debit the Cash account and credit Deferrred Revenue. When revenue is earned, Deferred Revenue is debited, and Revenue is credited.
Accrued Expenses and Accounts Payable
Both accrued expenses and accounts payable are considered accrued liabilities. Businesses need to record inventory purchases and expenses in the right accounting period in the financial statements. Accrue unpaid purchase invoices as accounts payable when they are not yet in the accounting system at month-end and goods were received during the month.
Cash vs. Accrual Accounting Method
Some small businesses use cash accounting instead of accrual accounting by recording transactions when cash is paid or received and preparing cash-basis financial statements. In the accrual method of accounting, transactions are recorded when revenue is earned or expenses or losses incurred, which can be before cash is received or paid.
When GAAP is followed, companies prepare financial statements using the accrual method of accounting. If cash transactions are paid when goods are received, or cash is received when the product is delivered, there are no differences between cash basis and accrual basis accounting methods.
The cash-basis method mirrors cash flow, whereas a separate indirect or direct cash flow statement must be prepared by companies following GAAP, through their accounting system, using accrual-basis accounting.
Small businesses prefer the cash method of accounting because business owners collect the cash before income taxes are payable on their taxable income for the calendar or fiscal year tax year.
The IRS allows corporations (excluding S-Corps and tax shelters), partnerships, and qualified personal service corporations (PSCs) with average annual gross receipts in the preceding 3 tax years of $25 million or less (indexed for inflation) to file a tax return using the cash method of accounting. Small businesses should consult a CPA to advise them whether to use cash-basis accounting or the accrual method of accounting for their financial and tax information.
More Examples of Accrual Accounting
An accrual accounting system uses GAAP accounting based on the accrual method to get revenue and expenses into the correct accounting period to which they relate. Accounting software is designed to make the accrual process easy and to reverse accruals automatically.
This section includes a detailed accrual basis accounting example relating to payroll and a summary list of when accrual based accounting is used.
Accrued Salaries & Wages and Accrued Payroll Taxes
Accrued liabilities for salaries & wages and related payroll taxes are an example of accrual accounting. This payroll example applies to companies with recurring scheduled pay periods that are weekly, bi-weekly, or monthly.
Accrued salaries & wages and payroll taxes are short-term liabilities. The time gap between incurring the expenses when work is performed and the related obligation to pay employees is less than one year (or the business operating cycle). Unpaid payroll and payroll taxes are accrued as of the end of each accounting period.
For payroll, the accrual accounting entry is to debit salaries & wages expense and credit the short-term liability account named accrued salaries & wages. For payroll taxes, debit the specific payroll tax account as an expense and credit the related short-term liability as accrued payroll taxes. When cash payment is made by direct deposits to employee bank accounts or payroll checks, the accrued liability credit is reversed, and the cash account is credited. When payroll taxes are due and paid, then the same process is followed to reverse the accrued liability through a debit accounting entry and credit cash.
Where to Use the Accrual Method of Accounting
- Accrued revenue
- Accrued sales commissions
- Accrued product warranty obligations
- Accrued bonuses
- Accrued salaries & wages
- Accrued payroll taxes
- Accrued sick pay
- Accrued other expenses
- Accounts payable
- Accrued income taxes payable
- Accrued interest expense or accrued interest income
- Accrued loss contingencies (probable and estimable)
The above list, providing examples of accrual accounting, is not all-inclusive.
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How to Calculate Accruals
Understand accrual accounting 101, the basic concept of the accrual basis of accounting, when you calculate accruals. The goal is to get revenues and expenses assigned to the proper accounting period to which they relate, following GAAP accounting rules.
This section also explains how you record accruals in accounting.
For revenues, follow GAAP revenue recognition rules to decide when to record revenue. It’s an accrual-basis entry if you haven’t received the cash yet. For expenses, record the expense as a debit and accrue the short-term liability as a credit. When cash is received, debit the short-term liability account and credit Cash.
As an example of calculating accruals, consider accrued interest expense. Calculate the days in the month for which interest hasn’t been paid on a loan. Divide by total days in the month or a standard 30 days per month. Multiply that fraction by the monthly interest expense amount due on the particular loan.
An Example of Accrual Accounting: A monthly loan interest payment of $1,000 is due on October 15th, in the month following the September accounting close. Assuming a 30-day month, accrue 50% of the total, which is $500 at the September 30th month-end. Record two accrual accounting entries. The September 30th accrual accounting entry is debit interest expense $500 and credit accrued interest expense payable, a short-term liability account, for $500. When the loan interest payment is made on October 15th, make the second accrual accounting entry by debiting accrued interest expense payable and crediting the cash account.
To calculate accruals, make adjusting entries in the accounting system to recognize that accounting period’s revenue and expenses in the financial statements at each month-end and at the end of the year for accounting purposes. Record revenue when performance occurs, following GAAP standards for revenue recognition. For accrued expense liabilities and purchases accrued to accounts payable, reverse the accrued liability and credit Cash instead when the obligation is paid.
Accrual Accounting Summary
GAAP accrual accounting recognizes revenue and expenses in the accounting period to which they relate, matching revenue and expenses. According to GAAP, revenue recognition occurs when revenue is earned; expenses are accrued when an obligation to pay an expense was incurred. GAAP requires accrual accounting.
Unpaid purchases are recorded or accrued as accounts payable as of the end of each accounting period.
Loss contingencies are recorded as an accrual when a future event resulting in an obligation is probable and estimable (unless other GAAP rules apply).
Businesses following GAAP for their financial statements use accrual accounting principles. Using accrual accounting is important. The accounting industry addresses why accrual accounting is better than cash-method accounting when they compare accrual accounting vs cash accounting. Accrual accounting is preferable because the GAAP matching principle gives businesses better insight into their financial position.
Some small businesses use the cash method of accounting instead. The cash-basis method may be preferable for qualifying companies when filing income tax returns and advised to use the cash method of accounting by their certified public accountant (CPA).
The difference between cash and accrual accounting is that cash-basis accounting records transactions when cash is received or paid. Accrual accounting can recognize transactions before cash is received or paid.