Accrual accounting

Definition

Accrual accounting is a method of financial reporting where revenues and expenses are recorded when they are earned or incurred, regardless of when the actual cash transactions take place.

What is accrual accounting?

This approach aims to provide a more accurate picture of a company’s financial performance and position over a specific period.

In accrual accounting, revenue is recognised when it is earned, meaning when goods are delivered or services are performed, even if the payment has not been received yet. Similarly, expenses are recorded when they are incurred, irrespective of when the payment is made.

This method contrasts with cash accounting, where transactions are only recorded when cash changes hands. Accrual accounting is widely used by businesses to reflect a more comprehensive view of their financial activities and obligations, providing a more accurate representation of the company’s financial health.

Example of accrual accounting

Service provided, not yet paid:
- On December 15th, XYZ Marketing Services provides advertising services to a client, ABC Retailers, but does not receive payment immediately. The total invoice for the services is $5,000.
The accounting entry for this transaction is:
$Accounts receivable (A sse t) = $ 5, 000$
$Service revenue (R e v e n u e) = $ 5, 000$
This entry reflects an increase in the accounts receivable asset, representing the amount owed by the client, and an increase in service revenue. The revenue is recognized when the service is provided, regardless of when the payment is received.
Payment received in the next accounting period:
- On January 10th of the following year, ABC Retailers makes a payment of $5,000 to XYZ Marketing Services for the services provided in December.
The accounting entry for the payment is:
$Cash (A sse t) = $ 5, 000$
$Accounts receivable (A sse t) = $0$
This entry reduces the accounts receivable asset and increases the cash asset to reflect the payment received.

Accrual accounting recognises revenue when it is earned (when services are provided or goods are delivered) and expenses when they are incurred, regardless of the timing of cash transactions. In this example, revenue is recognised in the period when the advertising services are provided, even though the payment is received in another period.

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