What Is Accrual Accounting – And Why You Should Use It
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.
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.
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