What it means
A business that invoices a customer in December and is paid in January has earned the revenue in December: the work was done, the customer is committed, the money is coming. A business that uses electricity in December and receives the bill in January has incurred the cost in December.
Accrual accounting records both in December. Cash accounting would put them in January, giving a December that looks better than it was and a January that looks worse.
The method rests on two principles. The revenue recognition principle says revenue is recorded when the business has done what it promised, transferring goods or services to the customer.
The matching principle says the expenses of generating that revenue are recorded in the same period. Together they mean profit for a period reflects the economic activity of that period, not the timing of payments.
Accruals create balance sheet items that cash accounting never needs. Accounts receivable record sales made but not yet collected.
Accounts payable and accrued expenses record costs incurred but not yet paid. Prepayments record cash paid for future periods.
Deferred revenue records cash received for work not yet done. Depreciation spreads the cost of long-lived assets over the years they are used.
Each of these adjusts the timing of recognition away from the timing of cash. The cost of accrual accounting is complexity and judgement.
Someone has to estimate how much revenue a half-finished contract has earned, how long a machine will last, and which customers will not pay. That judgement is why accrual profit can be manipulated and why the cash flow statement exists to reconcile profit back to cash.
The benefit is that accrual accounts answer the question owners and investors actually ask: did this business make money this period, and what does it own and owe as a result?
In practice
Real-world examples.
Example
A subscription business that collects $1,200 for an annual plan recognises $100 of revenue each month and holds the rest as deferred revenue.
Example
A builder that completes 40% of a $500,000 contract by year end recognises $200,000 of revenue even though it has invoiced only $150,000.
Example
A shop that buys $10,000 of stock in November and sells it in December records the cost in December, when the related sales occur, not in November.
Think of it
“Accrual accounting is like tracking your diet by what you eat, not when you digest it. The meal counts when you consume it, even if your body processes it later.
Formula
Calculation
Accrual Profit = Revenue earned in the period minus Expenses incurred in the period
Cash Profit = Cash received in the period minus Cash paid in the period
Worked example. A design studio's December activity:
- Invoices raised for work completed in December: $50,000, of which $20,000 was collected in December and $30,000 in January
- Cash collected in December for November invoices: $35,000
- Salaries for December, paid on 31 December: $22,000
- Rent for January, paid in advance on 28 December: $4,000
- Electricity used in December, billed and paid in January: $1,500
- Annual software licence paid in July for twelve months: $12,000
Accrual basis for December:
- Revenue = $50,000 (earned in December)
- Expenses = $22,000 salaries + $1,500 electricity + $1,000 software ($12,000 / 12) = $24,500
- Profit = $50,000 minus $24,500 = $25,500
Cash basis for December:
- Cash in = $20,000 + $35,000 = $55,000
- Cash out = $22,000 + $4,000 = $26,000
- Cash surplus = $29,000
The two figures differ by $3,500 for the month, and the difference would be far larger in a month with big collections or big prepayments. Only the accrual figure describes December's performance; the cash figure describes December's bank balance.Case study
Seen in the real world.
A landscaping company kept its books on a cash basis for its first five years. Its owner was baffled by wild swings: a spring in which he collected deposits for summer projects showed enormous profit, while the summer in which he paid crews and bought materials showed losses, even though the projects were profitable. When he sought a bank loan, the lender could not make sense of the accounts.
His new accountant moved the business to accrual accounting, recording deposits as deferred revenue, recognising revenue as projects completed and accruing crew costs as they were incurred. The restated accounts showed steady monthly margins of 18% to 22%, the loan was approved, and the owner was able to price new work on real project margins for the first time.
Watch out
Common mistakes.
- Reading accrual profit as cash available. A profitable business can run out of cash if receivables grow or customers pay late.
- Forgetting to reverse accruals when the invoice arrives, which double-counts the expense.
- Recognising revenue when the order is received or the invoice is raised rather than when the work is delivered.
Questions
People also ask.
Do small businesses have to use accrual accounting?
Rules vary by country. Many allow very small businesses and sole traders to use cash basis for tax, but lenders and investors almost always expect accrual accounts.
What is the difference between an accrual and a prepayment?
An accrual records a cost incurred but not yet paid. A prepayment records cash paid for a cost belonging to a future period.
Why do accrual accounts need a cash flow statement?
Because accrual profit and cash movement differ, and readers need both to judge performance and solvency.
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