What Is Accrual Accounting – And Why You Should Use It
If you’re running a business or managing your finances, understanding how and when to record income and expenses goes beyond technical detail. It can fundamentally change how you view your profitability and growth. That’s where accrual accounting comes in.
Unlike the simpler cash accounting method, accrual accounting records income as you earn it and expenses as you incur them. It does this regardless of when the cash changes hands. This approach gives you a more accurate picture of your financial health. It’s especially useful when clients pay after you deliver services or vendors invoice you for goods or services you haven’t yet paid for.
In this blog, we’ll explain what accrual accounting is and how it differs from cash accounting. We’ll also explore why it might be the smarter choice for your business. Whether you’re a small business owner, a freelancer, or preparing to scale your company, understanding accrual accounting can help you make smarter decisions. It can also help you avoid costly surprises.
What is Accrual Accounting?
Accrual accounting recognizes revenues and expenses when you earn or incur them, not when you actually receive or pay the money. This approach is based on two foundational principles in accounting:
- The Revenue Recognition Principle: Revenue is recorded when a product is delivered or a service is performed, even if payment hasn’t been received yet.
- The Matching Principle: Expenses are recorded in the same period as the revenues they help generate, providing a clearer view of profitability.
This method contrasts sharply with cash accounting, which only records transactions when cash physically enters or leaves your business. Accrual accounting provides a more accurate reflection of financial performance over time, especially for businesses that offer credit or deal with long-term contracts.
How Accounts Receivable and Accounts Payable Work in Accrual Accounting
Two key components of accrual accounting are accounts receivable (AR) and accounts payable (AP). These accounts help businesses track the money customers owe them and the money they owe to others.
Accounts Receivable (AR)
– Accounts receivable represents money that your customers owe you for goods or services already delivered. In accrual accounting, you record this revenue immediately—even if the payment arrives 30 or 60 days later.
*Example: If you send a $5,000 invoice on April 10th for consulting services, you still record that revenue in April—even if the client pays in May.*
Accounts Payable (AP)
– Accounts payable refers to the money your business owes to vendors or suppliers for goods or services received. You record these expenses the moment you create the obligation—not when you make the payment.
*Example: If your business receives a $2,000 invoice for office supplies in March and pays it in April, you still record the expense in March.*
Why These Accounts Matter
AR and AP provide visibility into short-term cash flow and financial obligations, making it easier to:
- Forecast your actual cash position
- Plan for upcoming payments and receivables
- Understand your working capital needs
- Spot potential cash flow gaps before they become problems
Together, these accounts are essential for maintaining an accurate, forward-looking view of your finances—something that’s nearly impossible with cash-based accounting.
Accrual -vs- Cash Accounting: What’s the Difference?
Understanding the difference between accrual and cash accounting is essential when choosing the method that best fits your business. While both systems aim to track income and expenses, they do so in fundamentally different ways—especially in terms of timing.
Timing of Transactions
- Cash Accounting: You record revenue only when you receive cash, and record expenses only when you pay them. It’s a straightforward, checkbook-style approach.
- Accrual Accounting: You record revenue and expenses when you earn or incur them, regardless of when the money changes hands.
This timing difference can significantly affect how profitable your business appears—especially when you deliver services but haven’t received payment yet.
| Feature | Cash Accounting | Accrual Accounting |
|---|---|---|
| Revenue Recognition | When cash is received | When it is earned |
| Expense Recognition | When cash is paid | When it is incurred |
| Complexity | Simple and easy to manage | More complex, requires tracking AR and AP |
| Accuracy of Financial Picture | May be distorted by timing | Provides a true snapshot of profitability |
| IRS Compatibility | Allowed for small businesses | Required for businesses >$25M in gross receipts |
| Best For | Freelancers, very small businesses | Growing businesses, inventory-based businesses |
Cash Flow -vs- Profitability
Cash accounting can make a business appear profitable when it’s actually losing money—or vice versa. For example, if you’ve paid a large supplier invoice this month but haven’t yet collected on recent client invoices, your bank account may look empty even though you’ve earned more than you’ve spent.
Accrual accounting offers a more realistic view of financial health by showing both your current obligations and expected income. This is especially important for managing growth, preparing financial statements, and applying for loans or investment.
Why Accrual Accounting May Be Better for Your Business
While cash accounting might work for small operations and side hustles, many businesses outgrow its simplicity. Accrual accounting offers a deeper, more strategic view of your financial performance, and for many companies, it becomes not just a choice—but a necessity.
1) It Reflects the True Financial Health of Your Business –
Accrual accounting aligns income and expenses to the periods in which they actually occur, which means your profit and loss statements are far more accurate. This clarity is essential for:
- Tracking profitability over time
- Evaluating the performance of marketing campaigns or seasonal trends
- Making decisions based on revenue earned, not just cash in the bank
2) It Supports Better Forecasting and Planning
With accrual accounting, you can see not only what you’ve earned and spent, but also what customers owe you and what you owe others. This data empowers you to:
- Predict cash flow gaps in advance
- Budget more effectively
- Make informed hiring, investment, or expansion decisions
3) It Aligns With GAAP Standards
Generally Accepted Accounting Principles (GAAP) require accrual accounting because it ensures consistency and comparability across businesses. If you’re planning to:
- Seek investors
- Apply for business loans
- Eventually go public
…using accrual accounting is a smart (and often required) move.
4) It May Be Required by the IRS
If your business has more than $25 million in average gross receipts over the last three tax years, the IRS requires you to use accrual accounting. It’s also mandatory for businesses that:
- Maintain inventory (unless they qualify for an exemption)
- Are structured as C corporations with specific thresholds
5) It Scales With Your Business
As your business grows, transactions become more complex. You’ll likely have:
- More clients with extended payment terms
- More vendors with invoice cycles
- Recurring revenue or subscription models
Accrual accounting handles this complexity and scales with your needs—without sacrificing accuracy or insight.
Who Should Use Accrual Accounting?
Businesses With Inventory:
— Companies that buy and sell physical products benefit the most from accrual accounting, and in many cases, the IRS requires it. This method helps businesses match the cost of goods sold to the revenue they generate in the same period. As a result, they can track inventory movement more precisely and stay compliant with IRS regulations—especially when gross receipts exceed $25 million annually.
Service-Based Businesses With Invoicing Cycles:
— For service providers who invoice after completing their work, accrual accounting ensures they recognize income when they perform the service—not when they receive payment. This creates a more accurate view of income trends and helps track unpaid invoices more effectively. Professionals like consultants, designers, accountants, and legal advisors often fall into this category and stand to benefit from the financial clarity it brings.
B2B Companies With Payment Terms:
— Many B2B (business-to-business) companies operate with structured payment terms, such as net-30 or net-60. Accrual accounting records revenue when it is earned, providing a clearer picture of profitability even if the cash won’t arrive for several weeks. This approach eliminates the distortions caused by delayed payments and helps businesses stay on top of accounts receivable management.
Businesses Planning to Scale:
— Businesses preparing for growth often choose accrual accounting as it supports more robust financial analysis and reporting. Whether the goal is to hire staff, open new locations, or seek investment, accrual accounting produces GAAP-compliant financial statements that appeal to banks and investors. It also lays a foundation for financial systems that can grow with the company.
Freelancers or Solopreneurs:
— Although many freelancers default to cash accounting due to its simplicity, those who manage long-term projects, invoice in phases, or work with subcontractors may find accrual accounting more useful. It offers better visibility into earnings and expenses and helps independent professionals run their operations more like structured businesses.
How to Start Using Accrual Accounting
– Switching From Cash to Accrual –
If your business has been using the cash method, transitioning to accrual accounting requires a change not just in bookkeeping but in mindset. You’ll need to start recording income when it’s earned and expenses when they’re incurred, even if the cash hasn’t changed hands. For tax purposes, the IRS allows this change, but it does require filing Form 3115 (Application for Change in Accounting Method). This ensures the transition is officially recognized and that there are no discrepancies in reported income.
– Choosing the Right Tools –
Accrual accounting can be handled manually, but most businesses find it more efficient to use accounting software that supports this method. Programs like QuickBooks, Xero, and FreshBooks allow you to track accounts payable and receivable, schedule recurring invoices, and generate financial reports based on accrual principles. These tools are especially useful for keeping real-time tabs on your company’s financial health without requiring constant spreadsheet updates.
– Getting Professional Help –
While software makes accrual accounting more accessible, many businesses still choose to work with a professional accountant during the transition to avoid making a costly accounting mistake. An experienced accountant can help you reclassify past transactions, ensure your records align with IRS standards, and establish a reliable system that supports long-term financial health. For businesses that are growing or seeking financing, professionally prepared accrual-based statements add credibility and significantly improve your chances of securing funding.
Why Accrual Accounting Is Worth the Switch
Accrual accounting may seem more complex than the cash method, but the benefits it offers—especially for growing businesses—are substantial. By recording income and expenses when they’re earned or incurred, rather than when cash changes hands, you gain a more accurate and actionable view of your business’s financial health. This approach supports better forecasting, ensures compliance with accounting standards like GAAP, and lays a solid foundation for sustainable growth.
If your business works with independent contractors or issues invoices with delayed payment terms, accrual accounting becomes even more essential. It helps you stay on top of your accounts receivable while ensuring you’re recording non-employee compensation at the right time. For example, payments reported on Form 1099-NEC—commonly used to report freelance or contractor income—are typically tied to services rendered before the actual payment is made. Using the accrual method ensures these amounts are accounted for in the correct reporting period.
Whether you’re managing inventory, planning for expansion, or simply aiming for cleaner financial records, accrual accounting equips you with the clarity needed to make smarter business decisions. And if you’re unsure where to start, FormPros provides a reliable platform with expert-built tools to simplify your financial tasks. From generating compliant tax forms like the 1099-NEC to offering resources that help demystify accounting practices, FormPros is a valuable ally in keeping your business financially sound.
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