What financial statements use accrual accounting?

Difference between cash and accrual accounting

The difference between cash basis and accrual basis accounting comes down to timing. When do you record revenue or expenses? If you do it when you pay or receive money, it’s cash basis accounting. If you do it when you get a bill or raise an invoice, it’s accrual basis accounting.

Accrual accounting is a far more powerful tool for managing a business, but cash accounting has its uses.

What is cash basis accounting?

Businesses that use cash basis accounting recognise income and expenses only when money changes hands. They don’t count sent invoices as income, or bills as expenses – until they’ve been settled.

Despite the name, cash basis accounting has nothing to do with the form of payment you receive. You can be paid electronically and still do cash accounting.

Benefits of cash accounting

• It’s simple and shows how much money you have on hand
• You only have to pay tax on money you’ve received, rather than on invoices you’ve issued, which can help cash flow (but not all businesses are allowed to use cash basis accounting for tax so check with your tax office)

Downsides of cash accounting

• It’s not accurate – it could show you as profitable just because you haven’t paid your bills
• It doesn’t help when you’re making management decisions, as you only have a day-to-day view of finances

What is accrual basis accounting?

Businesses that use accrual accounting recognise income as soon as they raise an invoice for a customer. And when a bill comes in, it’s recognised as an expense even if payment won’t be made for another 30 days.

Benefits of accrual accounting

• You have a much more accurate picture of business performance and finances
• You can make financial decisions with far more confidence
• It can sometimes be easier to pitch for long-term finance

Downsides of accrual accounting

• It’s more work because you have to watch invoices, not just your bank account
• You may have to pay tax on income before the customer has actually paid you – if the customer reneges on the invoice, you can claim the tax back on your next return

Hybrid methods of accounting

Some types of businesses use a hybrid accounting system. They may base big financial decisions and things like loan applications on accrual accounting but use cash-basis accounting to simplify some elements of their tax. There are lots of rules around who can and can’t do this. Speak to an accountant or tax professional to find out what applies to you.

Accrual accounting gives a better indication of business performance because it shows when income and expenses occurred. If you want to see if a particular month was profitable, accrual will tell you. Some businesses like to also use cash basis accounting for certain tax purposes, and to keep tabs on their cash flow. But it’s rare to use cash accounting on its own.

And while it’s true that accrual accounting requires more work, technology can do most of the heavy lifting for you. You can set up accounting software to read your bills and enter the numbers straight into your expenses on an accrual basis. It will also record your invoices as income as you raise them. And if you run a hybrid accounting system, smart software will allow you to switch between cash basis and accrual basis whenever you need.

Adjustments for earned revenues or incurred expenses but are not yet recorded in the accounts

What is Accrual Accounting?

In financial accounting, accruals refer to the recording of revenues that a company has earned but has yet to receive payment for, and the expenses that have been incurred but that the company has yet to pay.  The method follows the matching principle, which says that revenues and expenses should be recognized in the same period for which they were incurred.

Such accounting practices, therefore, have a general impact on the handling of the income statement and the balance sheet. The affected accounts include accounts payable, liabilities and non-cash-based assets, goodwill, future tax liabilities, and future interest expenses, among others.

What is an Accrual (in plain English)?

What exactly is an “accrual”? If companies received cash payments for all revenues at the same time when they were earned, and made cash payments for all expenses at the time when they were incurred, there wouldn’t be a need for accruals. However, since most companies have some revenues in the year that were earned (i.e., good/services were delivered) but for which payment was not received, they need to account for those unpaid revenues.

The same applies to expenses. If companies incurred expenses (i.e., received goods/services) but didn’t pay for them with cash yet, then they need to be accrued.

The purpose of accrual accounting is to match revenues and expenses to the time periods during which they were incurred, as opposed to the timing of the actual cash flows related to them.

Categories in Accrual Accounting

In accounting, accruals in a broad perspective fall under either revenues (receivables) or expenses (payables).

1. Accrued Revenues

Accrued revenues are either income or assets (including non-cash assets) that are yet to be received. In this case, a company may provide services or deliver goods, but does so on credit.

Example

An example of accrued revenue is electricity consumption. An electricity company usually provides the utility to its consumer prior to receiving payment for it. The consumer uses the electricity and the meter counts the reading. Then, at the end of the billing period, the consumer is billed. During the month, the company pays its employees, it fuels its generators, and it incurs logistical costs and other overheads.

The electricity company needs to wait until the end of the month to receive its revenues, despite the during-the-month expenses that it has. Meanwhile, it must acknowledge that it expects future income. Accrual accounting, therefore, gives the company a means of tracking its financial position more accurately.

At the end of the month, when the company receives payment from its debtors (customers), receivables go down, while the cash account increases.

2. Accrued Expenses

An accrued expense refers to when a company makes purchases on credit and enters liabilities in its general ledger, acknowledging its obligations to its creditors. In accounting, it is an expense incurred but not yet paid. Common accrued expenses include:

• Interest expense accruals – Interest expenses that are owed but unpaid.
• Suppliers accruals – Operating expenses for goods or services rendered by a third-party supplier.
• Wage or salary accruals – These include salaries owed to employees who work for part of the month without having received their full earned monthly salary.

Example

Let’s take an example of a start-up company (Y) with an employee (Joe) who is under a cliff vesting plan, and who is also getting a vesting schedule incentive after five years of commitment. Joe becomes faithful, hardworking, and diligent in the course of working for the company. He makes it through the first year and thus receives his cliff vesting bonus, and qualifies for the subsequent five years of the rest of his vesting schedule bonuses.

However, during this period, Joe is not receiving his bonuses materially, as would be the case with cash received at the time of the transaction. Instead, Joe’s bonuses have been accruing. Parallel to that, Company Y’s liabilities have also been increasing.

In this case, it’s obvious that Company Y becomes a debtor to Joe for five years. Therefore, to carry an accurate recording of Joe’s bonuses, the company must make a bonus liability record to record these bonus expenses. When the company pays out Joe’s owed bonuses, the transaction will be recorded by the company debiting its liability account and crediting its cash account.

Prepaid Expenses vs. Accrued Expenses

Prepaid expenses are the payment opposite of accrued expenses. Rather than delaying payment until some future date, a company pays upfront for services and goods, even if it does not receive the total goods or services all at once at the time of payment. For example, a company may pay for its monthly internet services upfront, at the start of the month, before it actually uses the services.

Impact of Accrual Accounting

In addition to accruals adding another layer of accounting information to existing information, they change the way accountants do their recording. In fact, accruals help in demystifying accounting ambiguity relating to revenues and liabilities. As a result, businesses can often better anticipate revenues while keeping future liabilities in check.

Accruals assist accountants in identifying and monitoring potential cash flow or profitability problems and in determining and delivering an adequate remedy for such problems.

Recording Accruals

To record accruals, the accountant must use an accounting theory known as the accrual method. The accrual method enables the accountant to enter, adjust, and track “as yet unrecorded” earned revenues and incurred expenses. For the records to be usable in the financial statement reports, the accountant must adjust journal entries systematically and accurately, and they must be verifiable.

The Relationship between Accrual Accounting and Cash Accounting

Even though both accrual accounting and cash accounting methods serve as a yardstick of performance and the economic position of a company in a given fiscal year, financial transactions in accrual accounting are reported as they happen – both debits and credits. However, the recording of transactions in cash accounting occurs at the time of cash transactions.

FASB and IFRS Example

The Financial Accounting Standards Boards (FASB) has set out Generally Accepted Accounting Principles (GAAP) in the U.S. dictating when and how companies should accrue for certain things. For example, “Accounting for Compensated Absences” requires employers to accrue a liability for future vacation days for employees. Learn more about this example on FASB’s website.

International companies outside the U.S. follow IFRS standards. To learn more, visit their website.

Additional Resources

Thank you for reading CFI’s guide to Accrual Accounting. To continue learning and advancing your financial career, these additional CFI resources will be helpful:

• Adjusting Entries
• Depreciation Expense
• Projecting Income Statement Line Items
• Projecting Balance Sheet Line Items