Accrual accounting is the method of recording revenue when it is earned and expenses when they are incurred, whatever the timing of the cash. A sale made on credit in December counts as December revenue even if the customer pays in February; a December electricity bill counts as a December cost even if it is paid in January. The aim is a picture of what a business actually did in a period, not just what passed through its bank account.
Accrual accounting is required for financial statements prepared under IFRS Accounting Standards and US GAAP, and company law in many countries demands it. It is contrasted with cash accounting, which records items only when money changes hands. Accrual figures appear in the income statement and balance sheet; the statement of cash flows then shows the separate story of cash.
Accrual accounting in plain terms
Suppose you mow a neighbour's lawn every week in June and they promise to pay you for the whole month on 5 July. Did you earn that money in June or July? You did the work in June, so accrual accounting says June. The payment in July just settles what you were already owed.
The same idea runs the other way for costs. If you used petrol in June but paid the fuel card bill in July, the cost belongs to June. Accrual accounting lines up each month's earnings with the costs of producing them, which is why it gives a fairer view of how a month really went.
Accruals and deferrals
Most of the work of accrual accounting is done through period-end adjusting journal entries of four kinds:
- Accrued revenue. Revenue earned but not yet billed or paid, such as services delivered at month end; recorded as an asset, often within accounts receivable.
- Accrued expenses. Costs incurred but not yet billed or paid, such as wages earned by staff or utilities used; recorded as a liability alongside accounts payable.
- Deferred revenue. Cash received before the work is done, such as an annual subscription paid upfront; recorded as a liability, deferred revenue, and released as the service is delivered.
- Deferred expenses. Cash paid before the benefit is used, such as insurance or rent paid in advance; recorded as prepaid expenses and charged to expense over time.
Long-lived assets follow the same logic: the cost of a machine is spread over its useful life through depreciation, and the cost of many intangible assets through amortization.
A worked example
A design studio's June activity:
- It completes $10,000 of work, of which customers pay $6,000 in June and $4,000 in July.
- It receives $3,000 in June for a project that will be done in August.
- It pays June wages of $5,000 in June, and owes $1,000 for June software use, payable in July.
Under accrual accounting, June revenue is $10,000 (the August project is not yet earned) and June expenses are $6,000, so:
Under cash accounting, June receipts are $9,000 ($6,000 plus the $3,000 advance) and June payments are $5,000, giving a cash surplus of $4,000 as well, but for different reasons, and July and August would look quite different. The accrual figure of $4,000 of net income is tied to work actually done in June; the balance sheet also shows $4,000 owed by customers, a $3,000 liability for the unfinished project and a $1,000 accrued expense.
Principles behind it
Accrual accounting rests on recognising items in the period to which they belong. The IFRS Conceptual Framework describes accrual accounting as showing the effects of transactions and events in the periods in which they occur, even if the cash comes in or goes out in a different period. Revenue timing is governed in detail by revenue recognition rules (IFRS 15 and ASC 606). Costs that relate directly to revenue are recognised alongside it, an idea traditionally called the matching principle.
Who must use it:
- Companies reporting under IFRS or US GAAP. Accrual is required for all financial statements except the cash flow statement.
- India. Section 128 of the Companies Act 2013 requires companies' books of account to be kept on an accrual basis and under double entry.
- US federal tax. Under section 448 of the Internal Revenue Code, C corporations and partnerships with a C corporation partner must generally use the accrual method unless their average annual gross receipts fall under an inflation-indexed threshold, set at $25 million in 2018 law and $31 million for tax years beginning in 2025. Tax shelters cannot use the cash method at all.
- Governments. The International Public Sector Accounting Standards (IPSAS) set accrual standards for the public sector, and a growing number of governments report on an accrual basis.
Strengths and limitations
Accrual accounting gives a truer picture of profitability, makes periods comparable and shows obligations and claims that cash records miss, such as money owed to suppliers. Lenders and investors therefore rely on it, and it is the basis for measures such as working capital and EBITDA.
Its weaknesses follow from the same features. A profitable business on paper can run out of cash if customers pay slowly, which is why cash flow and cash forecasting are watched separately. Accruals rely on estimates and judgement, such as how much revenue has been earned on a long project, which creates room for error and, in some notorious cases, for earnings manipulation. It also demands more bookkeeping skill than a simple cash record.