Accrual Accounting Explained by Professional Accountants

Accrual accounting is the fundamental method of financial reporting that recognizes income when it's earned and expenses when they're incurred, regardless of when the cash is actually received or paid. It contrasts with the cash basis method, which only records transactions when cash changes hands. Accrual accounting is the foundation of accurate financial reporting because it adheres to the matching principle, ensuring revenues are aligned with the expenses that generated them in the correct accounting period. This approach provides a true economic picture of a business's performance, making it the preferred method for financial analysis, compliance, and strategic decision-making.

A Professional Accountant's Guide to Mastering Adjusting Entries for Accruals and Deferrals

Adjusting entries are the backbone of accrual accounting. They are non-cash transactions recorded at the end of an accounting period to bring account balances up to date and ensure that revenues and expenses are recognized in the correct period, thereby complying with both the revenue recognition and matching principles.

Types of Adjusting Entries:

• Accrued Revenues: Income earned but not yet billed or collected. This means the service or good has been delivered, but the cash is still pending. The adjusting entry debits Accounts Receivable and credits Revenue.

  • Example: If a company earns $10,000 in consulting fees in December but invoices the client in January, an adjusting entry should recognize the $10,000 as revenue in December to reflect when the service was performed.

• Accrued Expenses: Costs incurred but unpaid and unrecorded. This covers expenses for services or goods received for which a bill has not yet been processed or paid. The adjusting entry debits the expense account (e.g., Wages Expense) and credits a liability account (e.g., Wages Payable).

  • Example: Employee wages earned in the last week of the month but paid in the following month. The expense is accrued in the current month.

• Deferred Revenues (Unearned Revenue): Cash received before the revenue is earned. This represents a liability, as the company owes the customer the goods or services. The initial receipt is a debit to Cash and a credit to Unearned Revenue. The adjusting entry debits Unearned Revenue and credits Revenue as the service is delivered.

  • Example: A customer pays $1,200 for a one-year subscription. $100 is recognized as revenue each month, with the remainder staying in the Unearned Revenue liability account.

• Deferred Expenses (Prepaid Expenses): Payments made in advance for goods or services to be consumed later. This represents an asset until the item is used. The initial payment is a debit to the Prepaid Expense asset account (e.g., Prepaid Insurance) and a credit to Cash. The adjusting entry debits the Expense account (e.g., Insurance Expense) and credits the asset account as the benefit is consumed.

  • Example: Paying $6,000 upfront for six months of office rent. $1,000 is recognized as Rent Expense each month.

Professional Tip: Always perform adjusting entries at the end of each accounting period (monthly or quarterly) to align with the matching principle—ensuring expenses are matched to the revenues they help generate. Failure to do so distorts both the income statement and the balance sheet.

Expert Tips: Best Practices for Implementing Accrual Accounting in New Businesses

Transitioning to or starting with accrual accounting is a strategic step for small businesses aiming for growth. While it adds complexity, proper implementation can prevent significant financial restatements later.

 Best Practices for Implementation:

• Start with Strong Bookkeeping Software: Utilize cloud-based platforms like QuickBooks, Xero, or NetSuite from day one. These systems are designed with accrual functionality, automating many of the required entries and report generations.

• Create a Detailed Chart of Accounts: Develop a Chart of Accounts (COA) that includes specific accounts for Accounts Receivable (A/R), Accounts Payable (A/P), Prepaid Expenses, and Unearned Revenue. A detailed COA is essential for correctly classifying transactions under the accrual method.

• Train Staff on "Earned" vs. "Received": Ensure sales and billing staff understand the difference between when revenue is "earned" (performance obligation satisfied) versus when cash is "received." This prevents misclassification of advance payments.

• Perform Monthly Reconciliations: Reconcile all balance sheet accounts, especially cash, A/R, and A/P, at least monthly. This process catches errors in accrual and deferral entries early, avoiding major corrections at year-end.

• Document Your Accounting Policy: Write down your specific policies for revenue recognition (e.g., point of sale vs. completion of service) and expense capitalization/deferral. Consistent application of these policies is key for compliance with GAAP (Generally Accepted Accounting Principles).

Pro Insight: Accountants recommend adopting accrual accounting as soon as your business manages significant receivables, payables, or inventory. Waiting too long can lead to inaccurate profit reporting and major headaches during audits or funding rounds, as you'll have to retroactively convert all prior financial data.

Why Experienced Accountants Insist on Accrual for Financial Accuracy and Reporting

Professional accountants universally prefer accrual accounting because it presents the true economic reality of a business's operations over a specific time period. Cash accounting often produces misleading results because cash flow is simply a measure of liquidity, not profitability.

Key Advantages of Accrual Accounting:

For example, a business might look incredibly profitable under cash accounting in December solely because it received large prepaid customer payments. However, under accrual accounting, once future obligations (unearned revenue) and accrued expenses (pending bills) are recognized, the business might actually show a loss for the period. Accrual accounting reveals the actual sustainable profitability.

CPA Commentary: “Cash accounting may be simple, but accrual accounting tells the real story of performance. It’s the difference between running your business by your bank balance and by your balance sheet. The latter is how you build sustainable, predictable growth.”

Advanced Topics: Handling Complex Revenue Recognition Under Accrual (ASC 606)

For accountants working with large or service-based entities, particularly those in software, construction, or other long-term contract industries, mastering the principles of ASC 606 (Revenue from Contracts with Customers) is essential for accrual compliance.

Core Principle:

The core principle of ASC 606 is that revenue should be recognized when control of goods or services is transferred to the customer, which means the customer has the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset or service—not necessarily when payment is received or invoiced.

ASC 606’s 5-Step Model:

1. Identify the contract with a customer: Ensure an enforceable agreement exists.

2. Identify the performance obligations: Determine the distinct promises to transfer goods or services to the customer.

3. Determine the transaction price: Calculate the amount of consideration the entity expects to be entitled to.

4. Allocate the transaction price to each obligation: Distribute the total price among the distinct promises based on their relative standalone selling prices.

5. Recognize revenue when (or as) the entity satisfies each obligation: Revenue is recognized either over time (e.g., continuous service) or at a point in time (e.g., physical delivery).

Example: A Software as a Service (SaaS) company sells an annual subscription for $1,200, paid upfront on January 1st. Under ASC 606, the revenue is not recognized immediately. Instead, the company recognizes $100 of revenue monthly over the 12-month contract period, even though the full cash payment was received upfront. The remaining portion sits as an Unearned Revenue liability on the balance sheet.

Pro Accountant Note: Revenue recognition errors are among the most common causes of financial restatements. Maintaining detailed documentation of contracts, performance obligations, and the timing of deliverable transfer is essential for compliance and audit readiness under ASC 606.

Common Questions About Accrual Accounting Answered by a Certified Public Accountant (CPA)

Q1: Do all businesses have to use accrual accounting?

No. The IRS permits small businesses to use cash basis accounting for tax purposes if their average annual gross receipts (over the past three years) are under a certain inflation-adjusted threshold ($29 million for 2023). However, businesses that hold inventory for sale or are organized as a C-corporation must generally use accrual accounting regardless of size.

Q2: How does accrual accounting affect taxes?

 Accrual accounting generally provides a clearer picture of business performance. For tax purposes, the key difference is that accrual accounting can accelerate the recognition of taxable income (by recording A/R before cash is received) and defer the deduction of some expenses (by tracking prepaid expenses). This is why many small businesses prefer cash accounting until they are legally required to switch.

Q3: Can I switch from cash to accrual mid-year?

It’s technically possible, but CPAs strongly recommend doing it at the fiscal year-end. Switching mid-year significantly complicates the calculation of opening balances and requires careful prorating of expenses and revenues. Regardless of the timing, if the change is for tax purposes, you must file IRS Form 3115 (Application for Change in Accounting Method).

Q4: Is accrual accounting harder to audit?

 While accrual accounting is more detailed and complex than cash accounting, auditors prefer it. Accrual methods offer a better, more complete audit trail, full GAAP compliance, and a truer representation of economic activity, which facilitates the auditing process.

Q5: How often should adjusting entries be reviewed?

Monthly for internal reporting and management analysis is ideal. At a minimum, adjusting entries should be reviewed quarterly to ensure accurate financial statements for external stakeholders.

Conclusion

Accrual accounting is the gold standard for financial management. It not only satisfies regulatory and compliance requirements (like GAAP and IRS rules for larger entities) but also equips businesses to make the most reliable, data-driven decisions. Whether you’re a new entrepreneur establishing your first general ledger or a seasoned CPA managing complex contracts under ASC 606, mastering accrual principles ensures that financial reports reflect the true economic health of your organization.

For new businesses, adopting accrual accounting early is an investment. It builds a foundation for credibility, transparency, growth, and strategic insight—the undeniable hallmarks of sound financial leadership.