Accrual accounting is when accountants record revenue before receiving client payments for goods sold or services provided. That is, the revenue is recorded after the transaction happens (the good is sold or service provided) rather than when the cash is paid or received. For example, if a company sells goods on credit, it will recognize the revenue at the time of the sale, even though it may not receive the cash payment until later.
Accountants follow the matching principle, meaning expenses are matched with the revenue they generate and are recorded in the same accounting period. This ensures that the company’s financial statements accurately reflect its profits or losses made during an accounting period.
Bigger companies use accrual accounting if their average gross revenues are more than $25 million over the previous three years. Companies that typically make sales on credit have to follow accrual accounting no matter their size or revenue. This is because business financial transactions are not just a simple matter of exchanging goods for cash. Credit transactions are an important source of revenue and also need to be recorded. Accrual accounting provides more accurate information about the company’s current financial condition.
Accrual accounting vs. cash accounting
The main difference between accrual accounting and cash accounting is the type of transaction recorded. With cash accounting, the transactions are recorded only when cash is paid or received. Accrual accounting records payments when the transaction is made – irrespective of whether cash is exchanged.
Cash accounting may not give you the whole picture of the company’s finances because it does not take into account goods and services sold on credit. Accrual accounting helps companies get a sense of their financial transactions, both current and future, by recording revenue and expenses when they are incurred, regardless of when the cash is received or paid.
Types of accruals
Deferred revenue: In simple terms, this is prepaid revenue. Payment is made before the goods are delivered or the service has been provided. Like, when you pay an annual subscription for a membership. The company records this transaction as deferred revenue because they haven’t delivered the goods or services yet.
Accrued revenue: When a company provides goods or services but does not receive payment immediately. For example, any long-term services like your electricity, rent, or postpaid cellphone services would count as accrued revenue for the company, landlord, or phone service provider, respectively.
Prepaid expenses: What is deferred revenue for a company, is a prepaid expense for the consumer. The customer pays for the service but does not receive the full benefit of the services or products they purchase.
Accrued expenses: When a company has used a service or consumed a good, but has not yet been billed for it, the transaction is recorded as an accrued expense. What counts as accrued revenue for the company providing the service becomes an accrued expense for the consumer. Your electricity bill, for example, is an accrued expense because you receive invoices at the end of the billing cycle and not before.
