Definition
The accrual basis accounting method calls for the recording of economic business events as services are provided or consumed; not when cash is received or paid. Therefore, the accrual method of accounting requires the reporting of revenues as they are earned and expenses as they are incurred.
Explanation
The accrual basis of accounting is one of two commonly accepted accounting methods, the other being the cash method of accounting. While the accrual method requires the reporting of revenues as they are earned and expenses as they are incurred, the cash method calls for the reporting of cash transactions as they occur.
The accrual method of accounting follows the matching principle, which calls for the reporting of revenues and expenses in the same time periods in which they occur. This method is deemed a more accurate way to account for costs and revenues. It's also the most commonly used accounting method, especially among companies with over $5,000,000 in revenues.
The processes and systems required to support accrual accounting can be quite complex, and companies have some flexibility with rules governing the need for an accrual. Oftentimes, dollar value thresholds are established based on the potential impact on the company's financial statements. For example, a company with $10 billion in revenues may not require employees to accrue expenses that are less than $10,000. Companies may also be required to perform complex calculations involving unbilled revenues.
There are two balance sheet accounts which are critical to the accrual method of accounting:
Accounts Receivable: non-written promises to pay for goods or services received but not yet paid for by a customer.
Accounts Payable: balances owed to trade partners for materials, supplies, goods and services that were purchased on credit.
Example
Company A hires an implementation vendor to configure their new customer system over the next 24 months. The total vendor costs will be $48 million. Payments are made to the vendor based on milestones achieved in the project plan. The table below demonstrates how the accrual method aligns costs with the proper financial accounting period.
Month | Cash Paid | Total Cash | Accrual | Total Accrual | Cash vs. Accrual |
June | $5,000,000 | $5,000,000 | $2,000,000 | $2,000,000 | ($3,000,000) |
July | $5,000,000 | $2,000,000 | $4,000,000 | ($1,000,000) | |
August | $5,000,000 | $2,000,000 | $6,000,000 | $1,000,000 | |
September | $5,000,000 | $2,000,000 | $8,000,000 | $3,000,000 | |
October | $5,000,000 | $2,000,000 | $10,000,000 | $5,000,000 | |
November | $10,000,000 | $15,000,000 | $2,000,000 | $12,000,000 | ($3,000,000) |
December | $15,000,000 | $2,000,000 | $14,000,000 | ($1,000,000) | |
January | $15,000,000 | $2,000,000 | $16,000,000 | $1,000,000 | |
February | $15,000,000 | $2,000,000 | $18,000,000 | $3,000,000 | |
March | $15,000,000 | $2,000,000 | $20,000,000 | $5,000,000 | |
April | $15,000,000 | $2,000,000 | $22,000,000 | $7,000,000 | |
May | $10,000,000 | $25,000,000 | $2,000,000 | $24,000,000 | ($1,000,000) |
June | $25,000,000 | $2,000,000 | $26,000,000 | $1,000,000 | |
July | $25,000,000 | $2,000,000 | $28,000,000 | $3,000,000 | |
August | $25,000,000 | $2,000,000 | $30,000,000 | $5,000,000 | |
September | $25,000,000 | $2,000,000 | $32,000,000 | $7,000,000 | |
October | $25,000,000 | $2,000,000 | $34,000,000 | $9,000,000 | |
November | $10,000,000 | $35,000,000 | $2,000,000 | $36,000,000 | $1,000,000 |
December | $35,000,000 | $2,000,000 | $38,000,000 | $3,000,000 | |
January | $35,000,000 | $2,000,000 | $40,000,000 | $5,000,000 | |
February | $35,000,000 | $2,000,000 | $42,000,000 | $7,000,000 | |
March | $35,000,000 | $2,000,000 | $44,000,000 | $9,000,000 | |
April | $35,000,000 | $2,000,000 | $46,000,000 | $11,000,000 | |
May | $13,000,000 | $48,000,000 | $2,000,000 | $48,000,000 | $0 |
Related Terms
The cash basis accounting method calls for the recording of economic business events as cash is received or paid. Therefore, the cash method of accounting requires the reporting of revenues when cash is received from customers and payments are made for expenses.
Moneyzine EditorNovember 6th, 2024
The matching principle is a financial accounting term that refers to a standard, which states that revenues generated in an accounting period need to be matched with the expenses incurred in that same accounting period.Moneyzine EditorNovember 6th, 2024
Also referred to as "receivables," this is the accounting term used to describe claims the company has against others for goods, services, or money. Accounts receivable are usually non-written promises to pay for goods or services received but not yet paid for by a customer.Moneyzine EditorNovember 6th, 2024
Also referred to as "payables," this is the accounting term used to describe balances owed to trade partners for materials, supplies, goods and services that were purchased on credit. Accounts payable recognizes the timing difference between the company's receipt of the benefit or asset, and the payment for this expense.Moneyzine EditorNovember 6th, 2024
The financial accounting term accrued expense refers to costs incurred during an accounting period, but not yet paid for in cash by a company in that same accounting period.Moneyzine EditorNovember 6th, 2024
The financial accounting term accrued revenue refers to income earned during an accounting period, but not yet recorded or received prior to the company's financial closing date.Moneyzine EditorNovember 6th, 2024
The term accrued market discount refers to the increase in the value of a bond as it approaches the day it is redeemable at par. The calculation of a bond's accrued market discount is not affected by falling interest rates.Moneyzine EditorJanuary 3rd, 2024
The term accrued interest refers to the funds that are payable but not yet received because of a timing difference of cash flows. Accrued interest is oftentimes use in the context of a bond or another type of fixed income security.Moneyzine EditorJanuary 3rd, 2024
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