What are Accruals?

What are Accruals | Accounting Smarts
Charles Hall

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Charles Hall

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March 1, 2021

Accrual accounting is a little more complicated and therefore often side stepped, however it's the more accurate method of accounting for your business.

There are two methods of accounting: cash basis accounting or accrual basis accounting. Cash basis accounting is simple, as you recognize revenue and expense when cash is received or paid. Accrual accounting is a little more complicated and therefore often side stepped by inexperienced business owners. However, accrual accounting is by far the more accurate method of accounting for your business. 

Accruals refer to the recording of both expenses and revenues when they have been incurred, rather than when the cash is paid, or payment is received. This is the best method to use for a clear, accurate picture of profitability. Simply put accruals match services to payments. 

If you have more questions about accruals, that's understandable, as the concept can be a bit difficult to understand. In this article, we will take a close look at accruals and how you can incorporate the accrual method into your small business financials. 

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A Clear Definition of Accruals

Accruals are the standard for large companies and a common way to manage small business finances. To gain an in-depth understanding of accruals, a breakdown of the definition may be necessary.

Instead of recording your revenue and expenses when the cash is received or cash is paid, in accrual accounting, the revenue and expenses are recorded when the service or product is delivered regardless if cash was involved.

The accrual method is in line with the matching principle of accounting, which states that both revenues and expenses must be recorded when they are incurred. Since you don't always pay bills simultaneously when you use the services or collect payment right when you sell an item, accrual accounting comes in handy. 

Accrual Accounting Examples

Perhaps you may benefit from a couple of examples. 

  • Services: When your company utilizes services that are to be paid later, but you record them now, you are utilizing the accrual accounting method. For example, when using the services of a writer, you may be billed sometime in the future, but you would record the expense, though you have not yet paid for the services. 
  • Wages: If you have employees who are paid a set wage, in accrual accounting, you will record their wages in the present, though you will not be actually paying them their wage until sometime in the future. 
  • Taxes: Business-related taxes accumulate over time. Using the accrual method, you would record those taxes as they are incurred instead of recording them when you pay the taxes.
  • Credit Card: When purchasing items on credit, the accrual method would require you to record those expenses right when the purchase is made, instead of recording the expense when you pay the credit card bill. 
  • Sales: When you make a sale, you record the revenue immediately, before the cash from the transaction is received from the customer.

Note: This is not an exhaustive list of examples of when you can use accrual accounting. There are many other cases when you'd use accrual accounting. 

Why Accrual Accounting is Preferred

Now that you have a basic understanding of how the concept of accrual accounting works let's examine why accrual accounting is preferred and why GAAP (General Accepted Accounting Principles) require such accounting.

The following section will let you know exactly why accrual accounting is preferred. 

GAAP Compliance

To meet the standard requirements for GAAP, you need to use accrual accounting. If you ever find yourself presenting your company's financial information to investors or other financial parties, accrual accounting presents a consistent method so financial standing can be compared across other companies. 

Clear Financial Picture

When accrual accounting is used, all of the revenue and expenses are recorded immediately. This means that, at any point, you can review your finances and tell if the company is profitable, rather than wondering what cash payments or receipts have not yet been processed.

Having a clear financial picture will allow you to plan for growth. Since accrual accounting gives you a real-time assessment of your finances, you will be able to quickly see where you are and plan for growth without uncertainty. 

For example, if you want to know whether the business was profitable in a specific month, figuring it out will be easy with accrual accounting. 

If you don't use this method, you will have some expenses and revenue that have not yet been recorded, and this will throw off your calculations. 

Keep Track of Credit

If your business depends on credit, accrual accounting can help you keep better track of your credit expenses. When you purchase items on credit, it's important to take inventory of your credit accounts. Businesses can fall into financial ruin if they aren't able to adequately manage their credit.

How to Record Using Accrual Accounting

We trust that you now have a solid understanding of what accrual is and why the method is helpful to all businesses. Now, we will go over how you should record transactions using accruals. 

In accrual accounting, you have two main types of transactions, which are: 

  • Accrued revenue. Sales that have been made by the company but not yet paid for. 
  • Accrued expenses. Expenses that were incurred by the company but have not yet been paid. 

How Accrued Expenses are Recorded

Most accruals will be for expenses unless your company regularly makes sales with the expectation of being paid at a later date. However, most accounting software handles sales on an accrual basis. 

You will record your accrued expenses and accrued revenue on your balance sheet under "current liabilities." This is because accrued entries are relatively short-lived. 

You can group your accrued expenses in common accounting categories, like: 

  • Wages payable: For wages that have been earned but not yet paid. These will be recorded as a credit. 
  • Interest payable: Record the accrued interest on purchases that you have not yet received an invoice for as a credit. 
  • Taxes payable: For taxes that have been accrued but not yet paid, record your taxes as a credit. 

The above are only a few categories that you can use to organize your accrued expenses. The list is not exhaustive. 

Do not record your accrued expenses in your accounts payable account. 

How Accrued Revenue is Recorded

Accruals are less commonly associated with revenue. However, your business may have some accrued revenue, and it's important to know how it should be recorded. 

Just like accrued expenses are to be recorded on your balance sheet as current liabilities, your accrued revenue should be recorded as current assets.

To record revenue that has been accrued but not yet paid, you should record it to your sales account as a credit AND your accrued revenue account as a debit. 

Do not record your accrued revenue in your accounts receivable account.

Accrual Accounting Vs. Cash Accounting

If you currently use cash accounting, you may wonder how accrual accounting differs. This section will compare accrual accounting to cash accounting so that you have an even deeper understanding of accrual accounting. 

The difference between accrual accounting and cash accounting has everything to do with timing. With cash accounting, revenues are recognized and recorded when customer payment is received, and expenses are recognized and recorded when the company pays their bill. 

This is very different from accrual accounting, in which revenues and expenses are recorded as soon as they are accrued. 

Also, cash accounting is often used by small businesses or businesses that don't hold inventory, while accrual accounting is required for any business that makes more than $25,000,000 in revenue. 

Here's a simple chart to show these differences: 

Accrual Accounting Cash Accounting
Record revenue when you make a sale. Record revenue when money is received.
Record expenses when you incur them. Record expenses when you pay for them.
Not required in any capacity. Preferred by small businesses. Required for large businesses, over 25M in revenue.

Final Thoughts

Now you know what accrual accounting is and how you can integrate it into your business's financial books. We hope that this article will serve as a helpful resource for your small business finance concerns! 

Charles Hall

Charles Hall

Charles has spent 25 plus years in the world of accounting and business. His experience includes working as a CPA/Auditor international accounting firms. He has worked as a controller and as a COO for small to medium sized companies.

Learn more about Charles Hall