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What is Accrual Accounting?

By Steve Smith

The information presented here is true and accurate as of the date of publication. DeVry’s programmatic offerings and their accreditations are subject to change. Please refer to the current academic catalog for details.

December 14, 2022
5 min read

 

 

Accrual accounting is a term you may have heard but its meaning remains a bit murky. Businesses of all types and sizes need to use different accounting methods to track their finances, get a clear picture of their cash flow, compare their financial performance over multiple accounting periods and determine what taxes are owed. Without being familiar with what this term means, it might be hard to see why it’s so important.

In this article, we’ll provide a detailed answer to the question: What is accrual accounting? We will also discuss how it works, its benefits, some of the different types of accruals and how accrual accounting differs from cash basis accounting. 

How Does Accrual Accounting Work?

Accrual accounting is one of two primary accounting methods used by businesses and individuals. The other method is called the cash accounting or cash-basis accounting. The accrual method is generally used by companies, while cash accounting is typically used by individuals. Businesses that follow the Generally Accepted Accounting Principles (GAAP) in recording and reporting their finances are required to use accrual basis accounting, as are businesses making an average of $25 million or more in sales for the preceding 3 years, according to IRS rules.

How does the accrual method of accounting work? In accrual accounting, revenues and expenses are recognized and recorded when transactions occur, rather than waiting for payment. This accounting method is based on the matching principle of GAAP, which states that all revenue and expenses must be reported in the same period and matched so that profits and losses for the period can be determined.

Accrual accounting is intended to offer a more accurate picture of a business’s  financial condition. Under the accrual method, if a company receives a purchase order from a customer, the order is recorded as revenue even though the customer’s payment may not be received until days, weeks or months later. The same method applies to the company’s expenses. Again applying the matching principle, they are recorded as expenses even though payment has yet to be made.

Types of Accruals

When following the accrual accounting method, 4 types of accruals are typically recorded on the company’s balance sheet:

  • Deferred revenue: Also referred to as unearned revenue, this type of accrual is recorded when a business receives cash before a good is delivered or a service provided. It goes on the balance sheet as a liability because the company is obligated to deliver the goods, or the services, in the future. 

  • Accrued revenue: In this accrual type, the business has delivered the goods or services, but hasn’t yet received payment. Accounts like these are typically seen in long-term projects or loans where milestones are established and met. 

  • Prepaid expenses: This account is created when a company pays up-front for something before the good or service has been provided. It’s an asset account because it shows the company is entitled to receive the goods or services in the future. 

  • Accrued expenses: Also known as accrued liabilities, accrued expenses occur when a company incurs an expense and hasn’t been billed for it yet. In this case, the company has received the merchandise or service and will pay for it in the future and in the meantime the expense is an accrued liability.

Accrual Accounting vs. Cash Accounting

What’s the difference between these two accounting methods? In accrual-based accounting, revenues and expenses are reported as they are earned and incurred, respectively. This takes place through sales and purchases on credit and by using accounts receivable and accounts payable. In cash accounting, revenues and expenses are reported as they are received and paid simply through inflows and outflows of cash.

When the two methods are compared, it becomes clear that the accrual accounting method offers certain advantages, which will become apparent in the next section.

The Benefits of Accrual Accounting

While accrual accounting is the more complex of the two accounting methods, it is considered the standard accounting practice for most businesses, except small businesses operating on an all-cash basis, and provides some distinct advantages:

  • By using accrual accounting, companies can look at both current and expected cash flows, providing a much more accurate picture of the organization’s financial health.

  • Accrual accounting shows underlying business transactions, not just those involving cash. Many transactions may be relatively straightforward, with payment received or made at the time of the transaction. Other transactions, which may be more complex, involve buying and selling on credit. This requires the company to account for monies that will be paid or received in the future.

  • Accrual-based accounting is likely to be more accurate regarding a company’s assets or liabilities. Adhering strictly to a cash-basis system, a company’s accounting may leave out crucial information regarding unpaid invoices or liabilities, which could cause the omission, however unintentionally, of certain assets.

  • The timing of when revenues and expenses are recognized can have a major effect on a company’s perceived financial health. One example of this can be found in the construction business, where a company may take on a long-term project and not receive cash payments until the project is completed. 

  • Using the accrual method, a company would benefit from something called the percentage of completion method, in which the construction company mentioned above, for example, would recognize a percentage of revenue and expenses proportionately as the project was completed. In this case, the accrual method would show the prospective lender a more complete picture of the company’s revenue channel. 

Preparing to Pursue an Accounting Career? DeVry Can Help

If you’re interested in helping businesses track and report their finances, we can help you begin your accounting career journey with our online Bachelor’s Degree in Accounting. Knowledgeable professors with real-world experience will help you build a strong foundation in accounting and economics along with a thorough understanding of business technology, government regulation, business administration and management in this online or hybrid program1.

Incorporating elements of Becker Professional Education’s industry-leading content2, this bachelor’s degree program offers the opportunity to gain exposure to core accounting principles that you’ll use in the field.

Study on your terms with DeVry. Our 6 academic sessions per year allow you to start when you’re ready and learn at your own pace, finishing on a regular or accelerated schedule.

1Program, course, and extended classroom availability vary by location. In site-based programs, students will be required to take a substantial amount of coursework online to complete their program.
2Credits and degrees earned from this institution do not automatically qualify the holder to participate in professional licensing exams to practice certain professions. Persons interested in practicing a regulated profession must contact the appropriate state regulatory agency for their field of interest. For instance, typically 150 credit hours or education are required to meet state regulatory agency education requirements for CPA licensure. Coursework may qualify for credit towards the State Board of Accountancy requirements. However, it is the student’s responsibility to contact the state board of accountancy for the jurisdiction in which they are applying to determine whether they have completed the appropriate credit hours and coursework to qualify to take the CPA exam. Employees of DeVry University and its Keller Graduate School of Management are not in a position to determine an individual’s eligibility to take the CPA exam or satisfy licensing. 

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