What it means
A business earns revenue by delivering goods or services, not by collecting cash; it incurs a cost by consuming a resource, not by paying for it. The accrual basis records those events at the moment they happen.
A sale on credit in March is March revenue even if the customer pays in May. Electricity used in March is a March expense even if the bill arrives in April.
A year's rent paid in January is an expense of each of the twelve months, not of January alone. The result is a profit figure that reflects the economic activity of the period and a balance sheet that shows what the business owns and owes as a consequence.
The method produces balance sheet items that cash accounting never needs. Accounts receivable record revenue earned but uncollected; accounts payable and accrued expenses record costs incurred but unpaid; prepaid expenses record cash paid ahead of the cost; deferred revenue records cash received ahead of the work; depreciation spreads the cost of long-lived assets.
Each is an adjustment that moves the recognition of an item away from the timing of its cash. The accrual basis requires judgement.
When exactly is revenue on a long contract earned? How long will a machine last?
Which customers will fail to pay? These estimates are where accounting standards spend most of their pages, where auditors spend most of their time, and where profit can be shaped.
That is the price of the method's benefit: it describes performance rather than cash timing, and performance involves estimation. Because accrual profit and cash can diverge sharply, the cash flow statement exists to reconcile them.
A reader who understands the accrual basis knows to look there: a business whose accrual profit consistently exceeds its operating cash flow is either growing fast or recognising revenue it is not collecting, and the difference between those two is the difference between a promising company and a failing one.
In practice
Real-world examples.
Example
A magazine publisher receives $1.2 million of annual subscriptions in January and recognises $100,000 of revenue each month, holding the balance as deferred revenue.
Example
A construction company recognises revenue on a two-year project as work is completed, invoicing at milestones and carrying the difference as accrued revenue or deferred revenue.
Example
A consultancy accrues its staff's December bonuses in December even though they are paid in March, so that December's profit bears the cost of December's work.
Think of it
“Accrual basis records transactions when they happen economically-not when cash moves.
Formula
Calculation
Accrual Revenue for the period = Cash received from customers + Increase in Receivables minus Increase in Deferred Revenue
Accrual Expense for the period = Cash paid for expenses + Increase in Accrued Liabilities and Payables minus Increase in Prepayments + Depreciation and other non-cash charges
Worked example. A training company's figures for a quarter:
- Cash received from customers: $150,000, of which $30,000 was for courses to be delivered next quarter
- Invoices raised for courses delivered this quarter but not yet paid: $45,000
- Courses delivered this quarter that were paid for last quarter (previously deferred): $20,000
- Cash paid to trainers and for venues: $70,000, of which $8,000 relates to next quarter's courses
- Trainer fees for this quarter's courses not yet invoiced by the trainers: $6,000
- Annual insurance of $12,000 paid at the start of the quarter
- Depreciation on training equipment: $2,500
Accrual revenue = $150,000 minus $30,000 (deferred to next quarter) + $45,000 (earned, unpaid) + $20,000 (earned now, paid earlier) = $185,000
Accrual expenses = $70,000 minus $8,000 (prepaid) + $6,000 (accrued) + $3,000 (one quarter of insurance) + $2,500 (depreciation) = $73,500
Accrual profit = $185,000 minus $73,500 = $111,500
Cash basis for comparison: cash in $150,000 minus cash out $82,000 ($70,000 + $12,000 insurance) = $68,000.
The accrual figure is $43,500 higher, mainly because it counts $65,000 of delivered-but-unpaid or previously-paid work as this quarter's revenue and spreads the insurance and prepaid costs. Next quarter, when the $45,000 is collected and the $30,000 of deferred courses are delivered, the cash and accrual figures will move the other way.Case study
Seen in the real world.
A courier franchise had always prepared its accounts on the cash basis and reported steady profits. The franchisor, standardising reporting across its network, required accrual accounts. The conversion revealed that the franchise had $180,000 of customer invoices outstanding, some six months old and unlikely to be paid; $95,000 of unrecorded liabilities for fuel, vehicle repairs and driver payments incurred but not yet invoiced; and a fleet of vans being expensed on purchase so that profit lurched from year to year depending on replacement timing.
Restated on the accrual basis, the franchise's profit over three years was 30% lower than reported, and its true position included a receivables problem the owner had never seen because the cash accounts did not show it. He hired a credit controller, recovered $110,000 of the old invoices, wrote off the rest, and now reads the receivables ageing every week. The franchisor's finance director remarked that the cash basis had not lied; it had simply not answered the questions that mattered.
Watch out
Common mistakes.
- Reading accrual profit as cash available. Profit can be tied up in receivables and stock; the cash flow statement shows what arrived.
- Recognising revenue when an order is received or an invoice raised rather than when the goods or services are delivered.
- Forgetting to reverse accruals when the invoice arrives, which double-counts the expense.
Questions
People also ask.
Is the accrual basis required?
For financial statements under IFRS and US GAAP, yes. Some tax authorities allow small businesses to use the cash basis for tax.
What is the difference between the accrual basis and the matching principle?
The matching principle is one of the ideas behind the accrual basis: expenses are recognised in the same period as the revenue they help earn. The accrual basis is the overall method.
Why do accrual accounts need a cash flow statement?
Because accrual profit and cash movements differ, and readers need to see both to judge performance and solvency.
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