Accrual Accounting Basics: A Guide for Employers

Keeping track of your company’s money in a consistent way is an essential part of being a responsible business owner. Accrual accounting is the most common form of modern accounting and can help you maintain a strong understanding of your company’s financial health at any given time.

 

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What is accrual accounting?

Accrual accounting is a financial recordkeeping strategy that involves tracking financial transactions at the time each one occurs. It takes invoices and outstanding payments into account when considering a company’s financial health. 

 

Income statements that report revenues on an accrual basis reflect all earnings even before the cash posts to a business’s bank account. Likewise, businesses that use accrual accounting record expenses as they are incurred even if they have not made the payment yet.

 

Purpose of accrual accounting

Accrual accounting exists so companies can accurately record the time period when financial transactions took place. When financial records only list the cash in and out of an account, they leave out important information about the timing of different expenses and sources of revenue. 

 

This is especially important when considering budgets for a certain period of time. For example, a company may bill a client for work done in November at the end of one fiscal year but might not receive the actual payment in their account until the start of the next fiscal year. Companies that have budgets for set periods rely on accrual accounting to ensure they are meeting their financial goals on an appropriate timeline.

 

Who uses accrual accounting?

Anyone can use accrual accounting to keep track of their business expenses, but certain types of businesses are legally required by the IRS to use accrual accounting:

  • C Corporations
  • Businesses with over $25 million in annual sales revenue over the past three years
  • Businesses with inventory

Businesses that fall outside of these requirements have the option to choose cash-based accounting methods, but accrual accounting may still be the best choice for small businesses. It is especially helpful for companies that make sales on credit.

Related: Different Accounting Professions: Key Titles and Duties

 

Types of accrual accounting records

All transactions in accrual accounting fall into one of two categories: accrued revenues and accrued expenses.

 

Accrued revenues

Income sources that haven’t submitted payment yet are known as accrued revenues. When people purchase an item on credit, they contribute accrued revenues to a company. Companies that send invoices to their clients after providing a service list the accrued revenues as soon as they notify the client that they owe money.

 

Accrued expenses

Accrued expenses are any outstanding bills a company has yet to pay. They include all the costs a business is still liable for. Examples of accrued expenses include employee wages and benefits, unpaid interest, raw materials and contracted services.

 

Recording prepaid expenses

When using accrual accounting, you will also have to keep track of your prepaid expenses and accounts. To track your prepaid costs, keep a dedicated prepaid account on your books that you can debit at the time of purchase. Then, record a credit on the bank account you used to make the payment. Prepayments are considered assets that decrease over time as you use up the payment. 

 

Consider a retail shop that pays for a year’s rent up-front for a total of $24,000. The prepayment would be listed as a $24,000 asset in your books according to accrual principals. As time passes, the asset depreciates by the monthly rent price and that cost is then reflected as an expense. At the end of a year, the prepaid asset account would be $0.

 

Frequently asked questions about accrual accounting

 

What is an example of accrual accounting?

A legal consulting firm that allows clients to pay using a monthly payment plan is an example of accrual accounting. They provide ten hours of service for a client and send them an invoice for $350 on April 15. The client agrees to pay $50 per month over the course of seven months, but the lawyer would record a $350 revenue in their books on April 15.

 

What is the difference between cash and accrual accounting?

The main difference between cash and accrual accounting is when the transactions are posted to company records. Cash accounting involves waiting until cash is in your account before recording income.

 

What is a disadvantage of accrual accounting?

Accrual accounting does not provide an overview of a company’s cash flow. Accountants overcome this challenge by producing periodic cash flow statements to compare to the company’s revenue and expenses.

 

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