Accrue: Definition, How It Works, and 2 Main Types of Accruals

In the world of accounting and finance, the term “accrue” is foundational to understanding how businesses track and report their financial activities. Whether you’re a small business owner, an accountant, or simply someone interested in financial literacy, grasping the concept of accruals can shed light on how companies maintain accurate and transparent records. This article explores the definition of “accrue,” how the accrual process works in practice, and the two main types of accruals—accrued revenues and accrued expenses. By the end, you’ll have a clear picture of why accruals are a cornerstone of modern accounting.

What Does “Accrue” Mean?

To “accrue” means to accumulate or increase over time, typically in the context of financial obligations or benefits. In accounting, it refers to the recognition of revenues or expenses that have been earned or incurred but not yet recorded in the books because cash has not yet changed hands. This concept is tied to the accrual basis of accounting, which differs from the cash basis. While cash accounting records transactions only when money is received or paid, accrual accounting recognizes economic events as they occur, regardless of cash flow.

The accrual method aligns with the matching principle, a key accounting guideline that dictates expenses should be recorded in the same period as the revenues they help generate. This ensures financial statements reflect the true economic activity of a business during a specific period, offering a more accurate picture of profitability and financial health.

For example, imagine a company provides a service in December but doesn’t receive payment until January. Under accrual accounting, the revenue is “accrued” and recorded in December when the service was performed, not when the cash arrives. Similarly, if a business incurs an expense—like utility costs—but the bill isn’t paid until the next month, the expense is accrued in the period it was used. This approach smooths out financial reporting and prevents distortions caused by timing differences in cash movements.

How Accruals Work in Practice

Accruals are not just theoretical—they’re an operational necessity for businesses adhering to Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). Let’s break down how the accrual process works step-by-step.

1. Identification of Economic Events
   The process begins when a company identifies a revenue or expense that has been earned or incurred but not yet documented with a cash transaction. This could be a service delivered, goods received, or an obligation like interest on a loan.
2. Journal Entry Creation
   Accountants record these events through adjusting journal entries at the end of an accounting period (typically monthly, quarterly, or annually). These entries ensure the financial statements reflect all relevant activities. For instance, if a company earns $5,000 in consulting fees in December but won’t receive payment until January, the accountant debits Accounts Receivable (an asset) and credits Service Revenue (a revenue account) for $5,000.
3. Balance Sheet and Income Statement Impact
   Accruals affect both the balance sheet and the income statement. Accrued revenues increase assets (e.g., Accounts Receivable) and revenues, while accrued expenses increase liabilities (e.g., Accounts Payable or Accrued Expenses) and expenses. This dual impact ensures the financial statements are comprehensive.
4. Reversal or Settlement
   Once the cash transaction occurs—payment is received or the bill is paid—the accrual is reversed or settled. Continuing the consulting example, when the $5,000 is paid in January, the accountant debits Cash and credits Accounts Receivable, clearing the accrual from the balance sheet.

This process requires diligence and often relies on estimates, especially for items like accrued interest or utilities. Accountants may use historical data, contracts, or invoices to determine the amounts to accrue, adjusting them as more precise information becomes available.

Why Are Accruals Important?

Accruals are essential for several reasons:

• Accuracy: They ensure financial statements reflect the true financial position and performance of a business, not just its cash flow.
• Compliance: Public companies and those audited under GAAP or IFRS must use accrual accounting to meet regulatory standards.
• Decision-Making: Managers, investors, and creditors rely on accrual-based reports to assess profitability, obligations, and growth potential.
• Tax Implications: In some jurisdictions, businesses can deduct accrued expenses before paying them, impacting tax planning.

Without accruals, financial reports could be misleading. A company might appear unprofitable in a month with heavy cash outflows (e.g., paying suppliers) even if it earned significant revenue, or vice versa. Accruals bridge this gap, aligning income and expenses with the periods they affect.

The 2 Main Types of Accruals

Accruals fall into two primary categories: accrued revenues and accrued expenses. Each type serves a distinct purpose in financial reporting, and understanding them is key to mastering the accrual concept.

1. Accrued Revenues

Accrued revenues, also called accrued income, represent money a business has earned but not yet received or recorded in cash form. These arise when a company delivers goods or services before invoicing or receiving payment, a common scenario in industries like consulting, construction, or utilities.

How It Works
Suppose a software company completes a $10,000 project for a client on December 20, 2025, but the client won’t pay until January 15, 2026. Under accrual accounting, the company records the $10,000 as revenue in December 2025 because that’s when the work was completed and the revenue was earned. The journal entry would be:

• Debit: Accounts Receivable $10,000
• Credit: Service Revenue $10,000

This increases the company’s assets (Accounts Receivable) and revenue on the income statement. When the client pays in January, the entry reverses:

• Debit: Cash $10,000
• Credit: Accounts Receivable $10,000

Examples of Accrued Revenues

• Interest Income: A bank earns interest on loans daily but may only receive payments monthly or quarterly.
• Rent Income: A landlord earns rent for December but receives the payment in January.
• Long-Term Projects: Construction firms often bill clients at milestones, accruing revenue as work progresses.

Accrued revenues are particularly important for businesses with long billing cycles or deferred payment terms, ensuring their financial performance isn’t understated.

2. Accrued Expenses

Accrued expenses, or accrued liabilities, are costs a business has incurred but not yet paid or recorded in cash. These obligations accumulate over time and are recognized to match expenses with the period they benefit.

How It Works
Consider a company that uses $2,000 in electricity during December 2025 but doesn’t receive the utility bill until January 2026. The expense is accrued in December to reflect the cost of operations for that month. The journal entry would be:

• Debit: Utility Expense $2,000
• Credit: Accrued Expenses (or Accounts Payable) $2,000

This increases expenses on the income statement and liabilities on the balance sheet. When the bill is paid in January:

• Debit: Accrued Expenses $2,000
• Credit: Cash $2,000

Examples of Accrued Expenses

• Wages and Salaries: Employees work in December but are paid in January.
• Interest Expense: A loan accrues interest monthly, but payment is due quarterly.
• Taxes: Property or income taxes owed for a period but paid later.

Accrued expenses prevent businesses from overstating profitability by ensuring costs are recognized when incurred, not just when paid.

Key Differences Between Accrued Revenues and Accrued Expenses

While both types of accruals follow the same principle of recognizing economic events before cash changes hands, they differ in their financial statement impact and purpose:

• Nature: Accrued revenues increase income and assets, while accrued expenses increase costs and liabilities.
• Focus: Revenues reflect earnings, whereas expenses reflect obligations.
• Examples: A sale not yet billed is accrued revenue; unpaid rent is an accrued expense.

Together, these two types ensure a holistic view of a company’s financial activities, balancing income and obligations.

Conclusion

The concept of “accrue” is more than just an accounting term—it’s a mechanism that ensures financial transparency and reliability. By recognizing revenues and expenses when they are earned or incurred, accrual accounting provides a clearer, more consistent view of a business’s performance than cash-based methods. The two main types of accruals—accrued revenues and accrued expenses—work in tandem to balance the books, reflecting both income generated and obligations owed.