What is Accrual Accounting? Types, Working, and Examples

Picture this: A business provides services today but gets paid next month. If it only recorded transactions when cash arrived, its financial reports might not truly reflect its earnings and expenses. This is where Accrual Accounting helps. But What is Accrual Accounting? It allows businesses to recognise revenue when earned and expenses when incurred, no matter when money is received or paid.  

In this blog, we’ll explore What is Accrual Accounting, how it works, along with an example, as well as its advantages and disadvantages. Why do businesses rely on this method, and how does it impact financial decision-making? Let’s dive in and uncover the answers. 

Table of Contents 

1. What is Accrual Accounting? 

2. How Accrual Accounting Works? 

3. Types of Accrual Accounting 

4. Example of Accrual Accounting 

5. Advantages and Disadvantages of Accrual Accounting 

6. Accrual Accounting vs Cash Accounting 

7. Best Practices for Accrual Accounting 

8. Conclusion 

What is Accrual Accounting? 

Accrual Accounting is a method where revenues and expenses are recorded when they are incurred or earned, not necessarily when cash is exchanged. This approach adheres to the matching principle, ensuring that income and expenses for a specific period are recorded in that same period. Compared to cash accounting, it offers a more precise view of a company's financial health. 

Accounting Manager’s average annual salary 

In Accrual Accounting, revenue is recorded when goods or services are delivered, even if payment is received later. Similarly, expenses are recorded when incurred, not when paid. This ensures financial statements accurately reflect a company’s performance by aligning income and expenses within the same period.  

This method helps businesses track profitability, manage obligations, and comply with financial reporting standards. It is widely used by larger companies with credit transactions, providing transparency for stakeholders and investors. 

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How Accrual Accounting Works? 

Accrual Accounting follows a structured process to ensure accurate financial reporting. The key steps include: 

1. Identify Transactions 

Determine all financial transactions that have occurred within the accounting period, including sales, purchases, and expenses. 

2. Record Revenues 

Recognise revenue when it is earned, regardless of when payment is received. For example, if a company provides a service in January but receives payment in February, the revenue is recorded in January. 

3. Record Expenses 

Record expenses when they are incurred, not when they are paid. For example, if a utility bill is received in January but paid in February, the expense is recorded in January. 

4. Make Adjusting Entries 

At the end of the accounting period, making changes to entries are made to ensure all revenues and expenses are properly accounted for: 

1. Accrued Revenues: Income earned but not yet billed or received. 

2. Accrued Expenses: Expenses incurred but not yet documented or paid. 

5. Handle Deferrals 

Adjust for any prepaid expenses or unearned revenues to reflect accurate financial data: 

1. Prepaid Expenses: Advance payments for upcoming expenditures (e.g., prepaid rent). 

2. Unearned Revenues: Payments received in advance for services or goods yet to be provided. 

6. Prepare Financial Statements 

Once all adjustments are made, financial statements are prepared using the adjusted trial balance. These include: 

1. Income Statement: Showing revenues and expenses for the period 

2. Balance Sheet: Displaying assets, liabilities, and equity 

3. Cash Flow Statement: Outlining cash movements within the period 

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Types of Accrual Accounting 

Accrual Accounting encompasses various types of transactions that make sure financial statements reflect the true financial position of a company. The primary types include: 

Accrued Revenue 

Accrued Revenue working 

Accrued revenue refers to income that has been earned but not yet received. This situation often arises in services provided on credit. For instance, a consulting firm may complete a project in March but receive payment in April. The revenue was recognised in March when the service was rendered. 

Prepaid Expenses 

Prepaid Expenses working 

Payments made before for goods or services that will be obtained later. These are recorded as assets until the benefit is realised. Common examples include insurance premiums or rent paid in advance. For example, if a company pays an annual insurance premium upfront, the payment is recorded as a prepaid expense and expensed monthly over the policy period. 

Deferred Revenue 

Deferred Revenue working 

Deferred revenue, or unearned revenue, occurs when a business is paid before providing goods or services. This is recorded as a liability until the obligation is fulfilled. For example, a software company may receive payment for a one-year subscription in advance. The revenue is recognised monthly over the subscription period as the service is provided. 

Accrued Expenses 

Accrued Expenses working 

Expenses incurred but not yet settled through payment. These are recorded as liabilities. Examples include wages earned by employees but not yet paid or utilities used but not yet billed. Recognising these expenses in the period they are incurred ensures accurate financial reporting. 

Example of Accrual Accounting 

Let's go through an example of Accrual Accounting to illustrate how it works in practice. 

Consulting Services 

Imagine a consulting firm, ABC Consultants, that provides services to a client. Here’s how Accrual Accounting would handle a specific transaction:  

Scenario 

1. Service Provided: ABC Consultants completes a project for a client on December 15th. 

2. Invoice Sent: The firm sent an invoice for   £7,900 on December 20th. 

3. Payment Received: The client pays the invoice on January 10th. 

Accrual Accounting Entries 

1. December 15th: Service is provided.  

2. No entry has been made yet because the revenue will not be recognised until the invoice is sent. 

3. December 20th: Invoice is sent 

4. The revenue is recognised when the invoice is sent, not when the payment is received. 

Journal Entry 

This entry records the revenue earned and the amount the client owes. 

January 10th: Payment is Received 

1. Cash Receipt: When the payment is received, it is recorded as a reduction in receivables. 

2. Journal Entry: 

This entry records the cash received and clears the amount owed by the client. 

Explanation 

1. Revenue Recognition: The revenue of   £7,900 is recognised in December when the service is provided, and the invoice is sent, even though the cash is received in January. 

2. Matching Principle: Any expenses related to the project (e.g., employee wages, materials) would also be recorded in December to match the revenue earned. 

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Advantages and Disadvantages of Accrual Accounting 

Here are the advantages and disadvantages of Accrual Accounting: 

Advantages of Accrual Accounting 

1. Accurate Financial Picture: Reflects true financial status by recording transactions when they occur. 

2. Better Financial Planning: Helps in budgeting and forecasting by recognising future income and expenses. 

3. Regulatory Compliance: Required by many financial reporting standards, especially for large businesses. 

4. Long-Term Decision Making: Provides a clearer view of financial trends, helping businesses plan for growth and sustainability. 

Disadvantages of Accrual Accounting 

1. Complexity: Requires detailed record-keeping and accounting expertise. 

2. Cash Flow Challenges: This may not reflect actual cash availability, leading to potential liquidity issues. 

3. Time-consuming: Involves frequent adjustments and reconciliations, making it more labour-intensive. 

4. Risk of Bad Debt: Recognising revenue before receiving payment increases the risk of uncollected receivables. 

Accrual Accounting vs Cash Accounting 

The below table outlines the difference between Accrual Accounting and Cash Accounting: 

Difference between Accrual Accounting and Cash Accounting 

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Best Practices for Accrual Accounting 

Here are some best practices for Accrual Accounting to ensure accuracy and efficiency: 

1. Follow a Close Checklist and Calendar: Maintain a detailed checklist and calendar for closing the books each month. This helps ensure accountability and timeliness. 

2. Verify Expenses and Revenue with Operations Team: Collaborate with your operations team to understand the activities during the month. This ensures that all revenues and expenses are accurately recorded. 

3. Review Payables and Receivables Aging Monthly: Regularly review the ageing of accounts payable and receivable to manage cash flow effectively and identify any overdue accounts. 

4. Enforce Segregation of Duties: Implement segregation of duties to prevent fraud and errors. Different individuals should handle different aspects of financial transactions. 

5. Review Reconciliations and Financial Statements: Regularly review reconciliations and financial statements to enhance accuracy and completeness. This includes reconciling bank statements, accounts receivable, and accounts payable. 

6. Define Materiality Threshold: Establish a materiality threshold to determine the significance of financial transactions. This helps focus on the most impactful items and ensures efficient use of resources. 

7. Prepare Annual Budget and Forecasts: Develop an annual budget and regularly update forecasts to plan for future financial needs and track performance against goals. 

8. Conduct Monthly Variance Analysis: Perform variance analysis to compare actual results against the budget. Investigate and understand the reasons for significant variances.  

9. Ensure Accurate Revenue Recognition: Follow the revenue recognition principle accurately, especially for businesses offering subscriptions or bundled services.  

10. Use Accounting Software: Utilise reliable accounting software to automate processes, reduce errors, and improve efficiency. 

Conclusion 

Understanding What is Accrual Accounting is essential for accurate financial reporting and business planning. Recording transactions when they occur, not when cash is exchanged, it provides a clearer financial picture. Though complex, it helps businesses manage profitability, adhere to regulations, and make informed decisions for long-term success. 

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