What it means
Under the accrual basis, a sale counts when the goods are delivered or the service is performed, even if the customer pays next month. Likewise, an expense counts when the business uses the goods or services, even if the supplier is paid later.
The aim is to match revenues with the costs that helped to earn them. The alternative is cash basis accounting, which records only actual cash receipts and payments.
Cash basis is simpler and works for very small businesses, but it can mislead. A company that pays a large annual bill in January would look unprofitable in that month and unusually profitable in the rest.
To apply the accrual basis, accountants book entries such as accrued expenses (costs incurred but not yet paid), accrued revenue (income earned but not yet billed), prepayments (costs paid in advance) and deferred revenue (cash received before the work is done). These adjustments keep each period honest.
They are made at the end of each period as part of the closing process. Accrual accounting is required under IFRS and US GAAP for most companies, and tax authorities often require it above a certain size.
Lenders and investors prefer it because it shows the underlying economics of the business. It also makes comparisons between periods fair.
The trade-off is that profit and cash can diverge. A business can be highly profitable on an accrual basis and still run out of cash if customers pay slowly.
This is why accrual accounts are always read alongside a cash flow statement. Smaller businesses sometimes use a hybrid approach.
They may keep cash-basis books through the year for simplicity and then convert to accrual at year end for the lender or the tax return. This works, but the conversion needs care, since missing a large unpaid bill or an uncollected invoice distorts the year.
In practice
Real-world examples
Example 1
A law firm completes $40,000 of work in June and invoices the client in July. Under the accrual basis, the revenue is recorded in June because that is when the work was done. The cash arrives in August, which has no effect on when the firm recognises the revenue.
Example 2
A retailer pays $12,000 in January for a year of rent. Under the accrual basis it records $1,000 of rent expense each month, not $12,000 in January. Monthly profit is therefore stable and comparable, whereas a cash view would show a big loss in January.
Example 3
A magazine publisher receives $60,000 of annual subscriptions in advance. It cannot record all of it as revenue immediately; instead it recognises $5,000 each month as the issues are delivered. The unearned portion sits on the balance sheet as a liability.
Think of it
Accrual basis records transactions when they happen economically-not when cash moves.
Formula
Calculation
Accrual profit = Revenue earned - Expenses incurred
Cash profit = Cash received - Cash paid
A consultancy earns $90,000 of revenue in a month, but $30,000 of it has not yet been collected, and it incurs $60,000 of expenses, of which $10,000 is unpaid. Accrual profit = $90,000 - $60,000 = $30,000. Cash received is $90,000 - $30,000 = $60,000 and cash paid is $60,000 - $10,000 = $50,000, so cash profit = $60,000 - $50,000 = $10,000. The $20,000 difference is the extra $30,000 owed by customers minus the extra $10,000 owed to suppliers.Case study
Seen in the real world
Keystone Interiors is a fictional design studio that, in this illustrative story, kept its books on a cash basis. In a quarter in which clients paid late, the owner saw almost no money coming in and decided to cancel a hire, even though the studio had completed $180,000 of work.
An outside accountant switched the books to the accrual basis and showed that the studio had actually earned $180,000 in the quarter, with $110,000 still waiting to be collected. The business was strong; the problem was collection, not demand.
The owner reinstated the hire and focused on chasing invoices. By the next quarter the receivables had been collected and the cash and accrual results had come back into line, and the owner kept the accrual books going from then on.
Watch out
Common mistakes
- Assuming profit equals cash. Under the accrual basis, a profitable business can still be short of cash.
- Recording revenue when the invoice is sent instead of when it is earned. Billing and earning are not always the same event.
- Forgetting to record expenses that have been incurred but not yet invoiced. This overstates profit.
Questions
People also ask
What is the difference between cash basis and accrual basis?
Cash basis records transactions when money moves, while accrual basis records them when they are earned or incurred. Accrual is usually more accurate for assessing performance.
Do small businesses have to use accrual accounting?
Not always. Many tax authorities allow small businesses to use the cash basis below a certain size, though lenders may still ask for accrual figures.
Can a business switch from cash to accrual?
Yes, but it normally needs to adjust opening balances and may need approval from the tax authority. It is best done with an accountant, who can calculate the one-off adjustment and advise on the tax effect.
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