What Are Accruals? How Accrual Accounting Works, With Examples

ByObeydul Haque Reading Time: 7 minutes

In the world of accounting, accuracy and timing are everything. Businesses need to track their financial activities in a way that reflects reality, even when cash hasn’t yet changed hands. This is where accruals come into play. Accruals are a cornerstone of accrual accounting, a method widely used by businesses to record revenues and expenses when they are earned or incurred, rather than when payment is made or received. This article will explore what accruals are, how accrual accounting works, its benefits and challenges, and provide clear examples to illustrate its application in real-world scenarios.

What Are Accruals?

Accruals refer to the recognition of revenues or expenses in a company’s financial records before the actual cash transaction occurs. Essentially, accruals are adjustments made to account for economic events that have taken place but have not yet been settled in cash. They ensure that financial statements reflect the true financial position of a business at a given point in time, aligning with the matching principle in accounting. This principle states that revenues and their related expenses should be recorded in the same period to provide an accurate picture of profitability.

There are two main types of accruals:

  1. Accrued Revenues: These are revenues that a company has earned but has not yet received payment for. For example, a consulting firm may complete a project in December but not receive payment until January. The revenue is accrued in December to reflect the work done.
  2. Accrued Expenses: These are expenses that a company has incurred but has not yet paid. For instance, a business might use electricity throughout December but not receive or pay the bill until January. The expense is accrued in December to match it with the period in which it was used.

Accruals are typically recorded as adjusting entries in a company’s general ledger at the end of an accounting period, ensuring compliance with Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS), depending on the jurisdiction.

What Is Accrual Accounting?

Accrual accounting is an accounting method that records revenues and expenses when they are earned or incurred, regardless of when the cash transaction occurs. This contrasts with cash-basis accounting, where transactions are recorded only when cash changes hands. Accrual accounting provides a more comprehensive view of a company’s financial health by recognizing economic events as they happen, not just when payments are made or received.

The accrual method is based on two key principles:

  • Revenue Recognition Principle: Revenue is recorded when it is earned, not when payment is received.
  • Matching Principle: Expenses are recorded in the same period as the revenues they help generate, not necessarily when they are paid.

For example, if a company sells goods on credit, accrual accounting recognizes the sale as revenue at the point of delivery, even if the customer pays weeks later. Similarly, if a business incurs an expense like rent but pays it in arrears, the expense is recorded in the period it applies to, not when the payment is made.

How Accrual Accounting Works

Accrual accounting operates through a systematic process of recording, adjusting, and reporting financial transactions. Here’s a step-by-step breakdown of how it works:

  1. Identify Economic Events: The first step is to identify revenues earned or expenses incurred during a specific period, regardless of cash flow. This could include sales made on credit, services rendered, or bills received but not yet paid.
  2. Record Adjusting Entries: At the end of an accounting period (e.g., month, quarter, or year), accountants make adjusting entries in the general ledger to account for accruals. These entries typically involve:
    • Debiting an asset account (e.g., Accounts Receivable) for accrued revenues or an expense account (e.g., Utilities Expense) for accrued expenses.
    • Crediting a liability account (e.g., Accounts Payable) for accrued expenses or a revenue account (e.g., Sales Revenue) for accrued revenues.
  3. Prepare Financial Statements: Once accruals are recorded, they are reflected in the income statement (revenues and expenses), balance sheet (assets and liabilities), and cash flow statement (adjustments to reconcile net income to cash flow).
  4. Reverse Entries (Optional): In some cases, accruals are reversed at the start of the next period when the cash transaction occurs, ensuring no double-counting.
  5. Monitor and Update: Accruals require ongoing monitoring to ensure accuracy, as estimates (e.g., for unpaid bills) may need adjustment based on actual payments or receipts.

Benefits of Accrual Accounting

Accrual accounting offers several advantages, particularly for businesses with complex operations or those required to follow GAAP or IFRS:

  • Accurate Financial Picture: By recording revenues and expenses when they occur, accrual accounting provides a clearer view of a company’s profitability and financial position over time.
  • Better Planning: Managers can use accrual-based financial statements to make informed decisions, as they reflect obligations and earnings in real time.
  • Compliance: Most regulatory bodies and investors require accrual accounting for publicly traded companies, making it essential for transparency and standardization.
  • Matching Revenues and Expenses: It aligns costs with the revenues they generate, offering a more logical representation of performance.

Challenges of Accrual Accounting

Despite its benefits, accrual accounting has some drawbacks:

  • Complexity: It requires more bookkeeping effort than cash-basis accounting, as it involves tracking receivables, payables, and adjusting entries.
  • Cash Flow Uncertainty: Since it doesn’t focus on cash transactions, accrual accounting may obscure a company’s immediate liquidity.
  • Estimates Required: Accruals often involve estimates (e.g., for unpaid invoices), which can introduce inaccuracies if predictions are off.

Examples of Accrual Accounting in Action

To illustrate how accruals and accrual accounting work, let’s explore some practical examples.

Example 1: Accrued Revenue – Consulting Services

Imagine a consulting firm, Apex Solutions, completes a $10,000 project for a client in December 2024. The client agrees to pay the invoice in January 2025. Under accrual accounting, Apex Solutions records the revenue in December, when the service was provided, not when the payment is received.

Journal Entry (December 31, 2024):

  • Debit: Accounts Receivable $10,000 (an asset increases)
  • Credit: Consulting Revenue $10,000 (revenue increases)

When the client pays in January 2025, Apex Solutions records the cash receipt: Journal Entry (January 2025):

  • Debit: Cash $10,000 (cash increases)
  • Credit: Accounts Receivable $10,000 (asset decreases)

This ensures the revenue appears in the 2024 income statement, reflecting the period when the work was done.

Example 2: Accrued Expense – Utility Bill

Consider a small business, GreenLeaf Café, which uses $500 worth of electricity in December 2024. The utility company sends the bill in January 2025, and GreenLeaf pays it then. Under accrual accounting, the expense is recorded in December, when the electricity was consumed.

Journal Entry (December 31, 2024):

  • Debit: Utilities Expense $500 (expense increases)
  • Credit: Accounts Payable $500 (liability increases)

When GreenLeaf pays the bill in January 2025: Journal Entry (January 2025):

  • Debit: Accounts Payable $500 (liability decreases)
  • Credit: Cash $500 (cash decreases)

This matches the expense to December’s operations, providing an accurate cost of running the café for that month.

Example 3: Prepaid Expense Adjustment

Sometimes, accruals involve adjusting for payments made in advance. Suppose GreenLeaf Café pays $1,200 for a year’s rent in January 2025, covering January to December. Under accrual accounting, the rent is spread across the year, with $100 accrued as an expense each month.

Journal Entry (January 2025, Payment):

  • Debit: Prepaid Rent $1,200 (asset increases)
  • Credit: Cash $1,200 (cash decreases)

Monthly Adjusting Entry (e.g., January 31, 2025):

  • Debit: Rent Expense $100 (expense increases)
  • Credit: Prepaid Rent $100 (asset decreases)

This ensures the expense is recognized monthly, not all at once.

Example 4: Accrued Salaries

A company, TechTrend Innovations, pays its employees $20,000 for work done from December 16–31, 2024, but the payroll is processed on January 5, 2025. The expense is accrued in December.

Journal Entry (December 31, 2024):

  • Debit: Salaries Expense $20,000 (expense increases)
  • Credit: Salaries Payable $20,000 (liability increases)

Journal Entry (January 5, 2025):

  • Debit: Salaries Payable $20,000 (liability decreases)
  • Credit: Cash $20,000 (cash decreases)

This reflects the labor cost in 2024, when the work was performed.

Accrual Accounting vs. Cash-Basis Accounting

To fully appreciate accrual accounting, it’s worth comparing it to cash-basis accounting. In cash-basis accounting, revenues and expenses are recorded only when cash changes hands. For instance, in Example 1, Apex Solutions would record the $10,000 consulting revenue in January 2025, when paid, not in December 2024. Similarly, GreenLeaf Café would record the $500 utility expense in January 2025, when the bill is paid.

While cash-basis accounting is simpler and ideal for small businesses with straightforward transactions, it can distort financial performance over time. Accrual accounting, though more complex, offers a truer reflection of long-term profitability and obligations, making it the preferred method for larger entities.

Real-World Applications

Accrual accounting is ubiquitous in industries like manufacturing, retail, and services, where credit transactions and long-term projects are common. For example:

  • A manufacturer might accrue costs for raw materials delivered in December but paid for in January.
  • A retailer might accrue sales revenue from holiday season credit purchases not settled until the new year.
  • A subscription-based company, like a streaming service, might accrue revenue monthly as users consume content, even if billed annually.

Conclusion

Accruals are a fundamental concept in accrual accounting, enabling businesses to record financial events as they happen, not just when cash moves. By recognizing revenues when earned and expenses when incurred, accrual accounting provides a more accurate and timely view of a company’s financial health. While it requires more effort than cash-basis accounting, its benefits—better decision-making, regulatory compliance, and precise matching of revenues and expenses—make it indispensable for most businesses. Through examples like accrued revenues for services, unpaid utility bills, prepaid rent adjustments, and accrued salaries, we see how accruals bridge the gap between economic activity and cash flow, ensuring financial statements tell the full story.

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