What it means
Under accruals accounting, the timing of the work decides the timing of the entry. If a company delivers a service in March, the revenue belongs to March even if the customer pays in May.
The same logic applies to costs, which are recorded in the period in which the business benefits from them. The idea behind it is called the matching principle, which says costs should sit in the same period as the revenue they helped to produce.
A salesperson's commission on a December deal belongs in December, even if it is paid in January. Without matching, a month's profit would depend on payment habits instead of on real business activity.
To make this work, accountants record adjusting entries at the end of each period. Accrued expenses capture costs already incurred but unpaid, accrued revenue captures income earned but not yet billed, prepayments capture costs paid in advance, and deferred revenue captures cash received before the work is done.
These entries move amounts between the profit and loss account and the balance sheet. The biggest benefit is a truthful picture of performance, but the biggest drawback is that profit and cash can drift far apart.
A fast-growing company can show healthy profits while its cash balance shrinks, because customers have not paid yet and suppliers need paying. For that reason the cash flow statement is always read alongside the profit and loss account.
Accruals accounting needs judgement, because some amounts must be estimated. A company may not yet have received the electricity bill, so it estimates the cost from past usage and corrects it when the invoice arrives.
Reasonable estimates, applied consistently, are accepted practice and are reviewed by auditors.
In practice
Real-world examples
Example 1
A property management firm collects rent for the full year in January. It records one twelfth of the rent as revenue each month, because the service of providing space is delivered gradually. The unearned part stays as a liability until the months pass.
Example 2
A manufacturer receives a delivery of components on the last day of the quarter but will not receive the supplier's invoice until next month. The finance team records the cost and the liability in the current quarter. Profit for the quarter then reflects the materials actually used.
Example 3
An advertising agency completes a campaign in November but invoices the client in December. It recognises the revenue in November, matched with the staff and media costs that made the campaign possible. Reported profit for November therefore shows the true result of the work.
Think of it
Imagine ordering a meal at a restaurant. Accruals accounting means you record the cost and the meal when you eat it. Cash accounting means you record it only when you eventually hand your credit card to the waiter at the end of the evening.
Formula
Calculation
Accrual profit = Revenue earned - Expenses incurred
Difference between accrual profit and cash movement = Increase in receivables - Increase in payables
A consultancy earns $80,000 of revenue in a quarter, of which it collects $50,000 in cash, and it incurs $55,000 of expenses, of which it pays $40,000. Accrual profit = $80,000 - $55,000 = $25,000. The cash movement is $50,000 - $40,000 = $10,000. The gap of $15,000 equals the $30,000 of revenue still owed by customers minus the $15,000 of expenses still owed to suppliers.Case study
Seen in the real world
Lakeside Landscaping is a fictional garden services company that, in this illustrative story, was owned by two partners who judged results by watching the bank balance. In spring the bank balance grew rapidly because customers paid for summer maintenance contracts in advance, and the partners decided to buy a second van.
The company's new accountant switched to accruals accounting and showed that only a quarter of the cash received had been earned so far. The rest was an obligation to provide services over the coming months, and the staff and fuel costs of delivering them had not yet been incurred.
The partners delayed the van purchase until the summer work had been done and the profit had been earned. By autumn the accrual profit and the cash balance had come together, and the second van was bought from real earnings instead of from customers' prepayments.
Watch out
Common mistakes
- Recording revenue when cash is received. Under accruals accounting, revenue is recorded when it is earned, which may be earlier or later.
- Ignoring costs that have been incurred but not invoiced. This overstates profit until the invoice arrives.
- Believing a profitable accrual result means there is cash available. Always check receivables, payables and the cash flow statement.
Questions
People also ask
Is accruals accounting the same as accrual basis?
Yes, the terms describe the same method. Different textbooks and countries use one or the other.
Why do lenders prefer accrual accounts?
They show the underlying economics of the business and make periods comparable. Cash-only records can swing wildly depending on when bills happen to be paid.
Do accruals ever get reversed?
Yes. An accrued cost is usually reversed at the start of the next period and replaced by the real invoice, so that the expense is not counted twice.