Skip to content

Form Pros

  • Business
    • Cease and Desist Letter
    • Contractor Agreement
    • Employee Termination Letter
    • Employment Verification Letter
    • Employment Agreement
    • General Partnership Agreement
    • Letter of Recommendation
    • LLC Operating Agreement
    • Loan Agreement
    • Non-Disclosure Agreement
    • Promissory Note
    • Purchase Agreement
    • Purchase Order
    • SBA Form 160
    • Vehicle Bill of Sale
  • Family & Personal
    • Child Medical Consent
    • Last Will And Testament
    • Living Will
    • Power of Attorney
    • Power of Attorney for Health Care
    • Revocable Living Trust
  • Real Estate
    • Commercial Lease
    • Commercial Sublease
    • Contract For Deed
    • Deed Of Trust
    • Eviction Notice
    • Letter of Intent
    • Month-To-Month Lease
    • Quitclaim Deed
    • Residential Lease
    • Residential Sublease
    • Warranty Deed
  • Tax Forms
    • Create Pay Stub
    • Form 1099-MISC
    • Form 1099-NEC
    • Form 2553 S Election
    • Form W-2
    • Form W-4
    • Form W-9
Home » Blog » What Is Accrual Accounting – And Why You Should Use It

What Is Accrual Accounting – And Why You Should Use It

Last updated September 28, 2022
What Is Accrual Accounting

It’s important to follow accounting standards, so that your financial results are comparable with other businesses. Investors, lenders, and regulators need financial statements that conform to the accrual method of accounting.  The accrual method presents a more accurate picture of company profitability.

Let’s start with a definition.

Accrual accounting defined

Accrual accounting posts revenue when it is earned, and expenses when incurred to generate revenue. This method of accounting matches revenue and expenses, so that both are posted in the same month. Accrual accounting disregards the impact of cash inflows and outflows when calculating profit.

Assume that you manage an IT business, and sign an agreement with an independent contractor who will install software and hardware for your clients. The agreement is for one year, and you will issue a 1099-MISC to the independent contractor for tax purposes.

On October 31st, the contractor bills you $1,000 for hours worked on the Standard Manufacturing account during the last week of October. You pay the invoice on November 2nd. Here are the accrual accounting entries for this activity:

  • October 31st: Increase wage expenses $1,000, increase wages payable $1,000
  • November 2nd: Decrease cash $1,000, decrease wages payable $1,000

The wage expenses are posted in October, when the hours are worked. This method allows you to match the wage expenses (and other expenses) with revenue earned from the Standard Manufacturing account during October. October revenue and expenses are compared to determine profit.

The accrual method is disconnected from the movement of cash. The wages are paid on November 2nd, but the expense is posted in October. The cash basis of accounting, on the other hand, posts revenue and expenses based on cash transactions.

Create Your 1099-MISC Form

Understanding the Cash Basis accounting

The cash method increases revenue based on cash inflows, and posts expenses when cash is paid. Here are the cash basis entries for the independent contractor:

  • October 31st: No accounting entry
  • November 2nd: Increase wage expenses $1,000, decrease cash $1,000

The cash basis method does not post the wage expense in October, when the expense was incurred. Instead, the expense is posted when cash is paid in November.

Let’s also assume that the client, Standard Manufacturing, pays you $5,000 on December 10th for an order shipped on October 20th. The October wage expense is posted in November (when cash is paid), and the October revenue is recorded in December (when cash is received).

The cash method does not match revenue with expenses, and your business profit is distorted. Did you make a profit on the Standard Manufacturing work? It’s hard to know, because revenue and expenses are not matched. Using the cash basis method is a common business mistake.

Accrual accounting requires businesses to use accounts payable and accounts receivable balances.

Using accounts payable and accounts receivable

Payable and receivable accounts allow you to record revenue and expense transactions using the accrual method. You post to these accounts before cash is received or paid. Wages payable (used above) is similar to accounts payable, because each account records a liability.

To explain the concept, assume that Bob and Sally form a partnership that manufactures sporting goods equipment. Bob runs operations, and receives a $2,000 bill for equipment repairs when services are provided on October 27th. Sally manages sales, and ships a $6,000 baseball uniform order to customer on October 30th. Here are the accounting entries, using accrual accounting:

  • October 27th: Increase repair expenses $2,000, increase accounts payable $2,000
  • October 30th: Increase sales $6,000, increase accounts receivable $6,000

Both the expenses and the revenue (sales) are posted in October. The expenses are posted when the services are provided, not when cash is paid. In a similar way, revenue is recorded when goods are shipped to the customer, not when cash is received.

Finally, customer deposit and prepaid accounts are used when cash moves before revenue or expense balances are posted.

Recording customer deposits and prepaid expenses

When a customer makes a cash deposit before a good or service is delivered, you increase cash and also increase customer deposits (a liability account). You’re obligated to deliver the good or service, or the deposit must be returned. When a product is delivered, you increase sales and reduce the customer deposit balance.

Assume that you pay six months of commercial insurance premiums in advance, totaling $6,000. You increase prepaid insurance and decrease cash to record the payment. At the end of each month, you increase insurance expenses and decrease prepaid insurance for $1,000. At the end of six months, the entire $6,000 balance is posted to insurance expenses.

Managing your daily operations is challenging, and you can make life easier if you use the right resources

Use technology to save time

Use Form Pros to create legal forms and contracts for your business. Our intuitive forms ask the right questions to quickly generate documents at a fraction of the cost of hiring a lawyer. You can create independent contractor agreements, general partnership agreements, and 1099 tax forms, using Form Pros. Save time on paperwork, so you can focus on growing your business.

Create Your 1099-MISC Form

Recent Posts

  • Form 1099-MISC vs 1099-NEC: What You Need To Know.
    With the inclusion of the 1099-NEC tax form, the Internal ...
  • Understanding Your Pay Stub: All About YTD
    Whether you’re a business that creates the pay stubs or an ...
  • How Long Should You Keep Your Pay Stubs?
    Whether you are an employer, formal employee, or ...
  • W-9 vs W-4 Forms: What’s the Difference?
    There are over 800 different Internal Revenue Service (IRS) ...
  • The Definitive Guide To Understanding Your Paycheck Stub Abbreviations
    So, you’ve received your monthly paycheck and now you’re ...

We Can Help You!

  • Instant download
  • Preview pre-purchase
  • Expert help
  • Easy to follow steps
Create 1099-MISC Form

Form Pros

  • Home
  • Blog
  • Testimonials
  • Account
  • Contact Us

About Form Pros

BBB Accredited Business Form Pros offers online generators for legal, tax, business & personal forms.

132 W. 36th Street, New York NY 10018

Customer Support

1(855) 881-2648

support@formpros.com
Hours: Mon-Fri. 9am – 5pm EST.

Chat
Terms & Conditions Privacy Policy Refund Policy