Accrual method

Accrual method of accounting is a system for recording financial transactions based on when economic events occur rather than when cash is exchanged ^[1]. Under this approach revenues are recognized when earned and expenses are recognized when incurred regardless of the timing of related cash receipts or payments. The accrual method provides a more accurate picture of an organization's financial position and performance than cash-based alternatives and is required under generally accepted accounting principles and international financial reporting standards.

Historical development

The principles underlying accrual accounting emerged with the development of double-entry bookkeeping in medieval Italy. Early merchants recognized that tracking credit transactions required recording obligations and entitlements before cash changed hands ^[2]. As commercial enterprises grew more complex and capital-intensive the limitations of purely cash-based records became increasingly apparent.

The industrial revolution accelerated the need for accrual concepts. Manufacturing businesses invested in equipment and facilities that provided benefits over many years and purchased materials that were converted to finished goods before sale. Recording these transactions only when cash moved would obscure the relationship between inputs and outputs and distort measures of periodic performance.

The professionalization of accounting in the late nineteenth and early twentieth centuries formalized accrual concepts into generally accepted practices. The establishment of securities regulations following the 1929 stock market crash made standardized financial reporting essential for investor protection ^[3]. Accrual-based financial statements became mandatory for publicly traded companies because they provided more meaningful information for investment decision making.

The codification of accrual principles continued through the twentieth century with increasing specificity. Revenue recognition standards evolved to address complex transactions and multiple element arrangements. The matching principle was elaborated to guide expense recognition. International convergence efforts have harmonized accrual concepts across jurisdictions though some differences persist.

Fundamental principles

The accrual method rests on two foundational concepts that determine when revenues and expenses appear in financial statements ^[4].

Revenue recognition principle

Revenue is recognized when it is earned meaning when the organization has substantially completed the activities that entitle it to receive payment. For goods this typically occurs upon delivery to the customer when title and risk of loss transfer. For services revenue is recognized as services are performed. The timing of payment is irrelevant to revenue recognition under the accrual method.

Current standards require that revenue be recognized when control of goods or services transfers to the customer. This occurs when the customer can direct the use of and obtain substantially all remaining benefits from the asset. Revenue is measured at the amount the organization expects to receive considering variable consideration such as discounts, returns and performance bonuses.

Matching principle

The matching principle requires that expenses be recognized in the same period as the revenues they help generate ^[5]. This cause-and-effect relationship ensures that income reflects the resources consumed in producing revenue. When expenses cannot be directly associated with specific revenues they are recognized based on systematic allocation or in the period when incurred.

Cost of goods sold is matched directly with sales revenue because the cost of inventory is recognized as expense when the inventory is sold. Depreciation allocates the cost of long-lived assets over their useful lives matching the cost with the periods benefiting from the asset. Selling and administrative expenses are typically recognized in the period incurred because their relationship to specific revenues is indirect.

Types of accruals

Several categories of transactions require accrual adjustments to properly reflect economic activity ^[6].

Accrued revenues

Accrued revenues represent amounts earned but not yet billed or collected. Services may have been performed or goods delivered but the organization has not yet invoiced the customer or received payment. An adjusting entry debits a receivable and credits revenue to recognize the earned amount.

Examples include interest revenue earned on investments but not yet received, rent revenue for periods completed but not yet billed, and service revenue for work performed before period end but billed subsequently. Without accrual the financial statements would understate both assets and revenues.

Accrued expenses

Accrued expenses are costs incurred but not yet paid or recorded. The organization has received goods or services and has an obligation to pay but payment has not occurred. An adjusting entry debits expense and credits a payable to recognize the obligation.

Common accrued expenses include wages earned by employees through period end but not paid until the following period, interest on debt that accumulates continuously but is paid periodically, utilities consumed but not billed until the next month, and taxes based on current period activities but payable later. Without accrual expenses and liabilities would be understated.

Deferred revenues

Deferred revenues arise when payment is received before revenue is earned. The customer pays in advance for goods or services to be delivered in the future. The payment creates a liability because the organization owes performance. Revenue is recognized as delivery occurs.

Subscriptions, membership fees, prepaid insurance from the customer's perspective and retainer payments all create deferred revenue. The initial entry debits cash and credits a liability. As services are performed or goods delivered the liability is reduced and revenue is recognized.

Prepaid expenses

Prepaid expenses occur when payment is made before the expense is incurred. The organization pays in advance for future benefits such as insurance coverage, rent or supplies. The payment creates an asset because future benefit exists.

The initial entry debits an asset and credits cash. As the prepaid item is consumed the asset is reduced and expense is recognized. Insurance expense is recognized over the coverage period. Rent paid in advance is expensed in the periods occupying the space. Supplies are expensed as used.

Adjusting entries

The accrual method requires adjusting entries at the end of each accounting period to update account balances before preparing financial statements ^[7]. These entries ensure that revenues and expenses are recognized in the proper periods.

Adjusting entries fall into two categories. Accruals record revenues earned or expenses incurred that have not yet been recorded through regular transactions. Deferrals allocate amounts previously recorded as assets or liabilities to expense or revenue as economic events occur.

The adjusting entry process involves analyzing each account to determine whether its balance properly reflects the economic reality at period end. Revenues that have been earned but not recorded require accrual entries. Expenses that have been incurred but not recorded require accrual entries. Prepaid assets that have been consumed require deferral entries. Unearned revenues that have been earned require deferral entries.

Comparison with cash basis

The cash basis of accounting recognizes revenues when cash is received and expenses when cash is paid regardless of when economic events occur ^[8]. This simpler approach provides clear information about cash flows but may not accurately reflect financial performance.

A business using cash basis might report a profit in a period when it collects payment for past sales while incurring significant expenses that will only appear when paid in future periods. Conversely it might report losses when paying for assets that provide future benefits. The mismatch between economic activity and cash flows distorts periodic income measurement.

Cash basis accounting is not permitted under generally accepted accounting principles for most businesses and is prohibited for publicly traded companies. However small businesses below revenue thresholds may use cash basis for tax purposes because of its simplicity. Some organizations maintain cash basis records for internal purposes while preparing accrual basis statements for external reporting.

Requirements and applicability

Generally accepted accounting principles in the United States and international financial reporting standards require accrual basis accounting for general purpose financial statements ^[9]. Publicly traded companies must use accrual accounting for SEC filings. Lenders and other stakeholders typically require accrual basis financial statements.

For United States tax purposes businesses with average annual gross receipts exceeding twenty-five million dollars for the three preceding years must use accrual accounting. Smaller businesses may choose cash basis for tax reporting though they may still need accrual statements for other purposes. Certain industries including those holding inventory for sale are generally required to use accrual methods.

Advantages of accrual method

The accrual method provides significant benefits for financial reporting ^[10]:

• Provides more accurate picture of financial position and performance
• Matches revenues with the expenses incurred to generate them
• Enables meaningful comparison across periods and between companies
• Satisfies requirements of GAAP, IFRS and SEC regulations
• Supports better decision making by stakeholders
• Reveals the full extent of assets and liabilities
• Reflects economic reality rather than cash timing

Limitations of accrual method

Despite its advantages accrual accounting has certain limitations ^[11]:

• More complex and costly to implement than cash basis
• Requires estimates and judgments that introduce subjectivity
• Does not directly show cash generation which is critical for liquidity
• May obscure cash flow problems if receivables are not collected
• Vulnerable to manipulation through aggressive revenue recognition or expense deferral
• Adjusting entries add complexity to month-end and year-end processing

Accrual method — recommended articles

Financial management — Standard — Decision making — Planning — Documentation — Quality control — Stakeholder — Management — Organization

References

• Kieso D.E., Weygandt J.J., Warfield T.D. (2022), Intermediate Accounting, John Wiley & Sons, 18th edition.
• Wild J.J., Shaw K.W. (2022), Fundamental Accounting Principles, McGraw-Hill Education, 25th edition.
• FASB Accounting Standards Codification Topic 606, Revenue from Contracts with Customers.
• Horngren C.T., Sundem G.L., Elliott J.A. (2021), Introduction to Financial Accounting, Pearson, 13th edition.
• Internal Revenue Service (2022), Publication 538 Accounting Periods and Methods.

Footnotes

1. Kieso D.E. et al. (2022), p. 98
2. Horngren C.T. et al. (2021), pp. 12-18
3. Wild J.J., Shaw K.W. (2022), pp. 5-10
4. FASB ASC Topic 606
5. Kieso D.E. et al. (2022), pp. 102-108
6. Wild J.J., Shaw K.W. (2022), pp. 125-135
7. Horngren C.T. et al. (2021), pp. 135-145
8. IRS Publication 538, pp. 8-12
9. Wild J.J., Shaw K.W. (2022), pp. 15-18
10. Kieso D.E. et al. (2022), pp. 108-110
11. Horngren C.T. et al. (2021), pp. 148-150

Author: Sławomir Wawak