What is Accrual Accounting and How it Works: Basics & Examples

Introduction

As organizations scale and work towards enhancing their customer experience, they leverage multiple payment methods and payment terms, which makes revenue recognition all the more complex. How and when organizations record revenues and expenses is extremely crucial to get an accurate picture of an organization’s financial position. This makes the selection of the right accounting method extremely important. 

Accruals are the records of revenue and expenses that have been earned and incurred, but actual cash transactions are yet to occur. It involves non cash assets and liabilities that are recorded on the balance sheet. Accruals are important as they ensure accuracy in financial statements and reporting. 

In this blog, we will understand what is accrual accounting, understand its intricacies and how it works, how it differs from other accounting methods, and its importance in showcasing a comprehensive financial health view of an organization. 

What Is Accrual Accounting?

Accrual accounting is an accounting method where revenue or expenses are recorded at the time in which they are earned or incurred, irrespective of when the actual cash transactions occur. It utilizes two core accounting principles, the matching principle and the revenue recognition principle. 

The matching principle states that all expenses must be reported in the same accounting period in which the related revenue is earned. While the revenue recognition principle states that revenue should be recognized when it is earned and not when actual cash exchange takes place. For public companies and for any other organizations that prefer GAAP (generally accepted accounting principles) compliance, they have to follow the accrual accounting method.

Accrual accounting basics 

Accruals and deferrals form the basis of the accrual accounting method. Here, accruals are the revenue or expenses that have been earned or incurred, but cash transactions are yet to occur. They are commonly referred to as accrued revenue and accrued expenses. 

Deferrals, on the other hand, are when an organization has received a pre-payment for a service or product that is not yet earned or they have paid for an expense which is yet to be incurred. They are also known as deferred revenue, deferred expense or prepaid expense. 

How Does Accrual Accounting Work?

The steps involved in accrual accounting are as follows:

1. Identify and track all transactions: The accrual accounting method starts with identifying all transactions that occurred in the accounting period. This involves identifying all the transactions related to revenue and expenses that have been earned or incurred, even if cash exchange has yet to take place. 
2. Categorize transactions: Once transactions are recognized, they need to be categorized into accruals and deferrals.
3. Make adjusting entries: Next organizations need to make adjusting entries on the balance sheet. To adjust entries specific account placeholders are created in the balance sheet which are: 
   • Account receivable- This is an asset account that records all revenues that are earned but cash transactions have yet to occur. 
   • Accounts payable- This is a liability account that records all expenses that have been incurred but are yet to be paid for. 
   • Deferred revenue- This is a liability account that records all revenues for which cash is received but not yet earned, i.e., the services or offerings are not yet delivered. 
   • Prepaid expenses- This is an asset account that records all expenses for which payment is made but that have yet to be incurred. 
4. Prepare financial statements: Once adjustments are made, the corrected account balances provide the basis for generating financial statements such as balance sheet, income statement and cash flow statement for that accounting period. 
5. Close the books: Next organizations need to close temporary accounts such as revenue and expenses for that accounting period. This involves making closing entries, which involve moving the net income or loss from the income statement to the retained earnings account on the balance sheet. This retained earnings account carries over to the next accounting period. 

Examples of Accrual Accounting

Accrued revenue example 

To understand accrued revenue let us take an example of a consulting firm, SBS Ltd, that provided consulting services to a client for a service fee of $10000 in January 2024. The organization generated the invoice on 30th January 2024. However, according to payment terms the client made the payment on 15th March,2024.Despite not receiving the payment in January, the consulting firm must recognize the revenue in January since they have already provided the service during that period and hence earned the revenue. Therefore, the accrued revenue for the firm in this case is $10000 and it will be recorded as given below.

SBS Ltd transactions entries for January 2024

SBS Ltd transactions entries for March 2024

Accrued expense example 

To understand accrued expenses, let us take the example of an organization, ABS Ltd, which procured laptops from their vendor, XYZ Ltd, in March 2024. They received the products on 10th March 2024, and an invoice for $15,000 from XYZ Ltd, on 30th March 2024. They made payment to the vendor on 15th April 2024. While the organization paid the vendor in April, they incurred the expense in March. Hence, they need to make accrued expenses related adjustments as follows:

ABS Ltd transactions entries for March 2024

ABS Ltd transactions entries for April 2024

Deferred revenue example

To understand deferred revenue let us take an example of a telecommunication service provider, DRG Ltd. They have received a payment of $2000 from a customer in February 2024, for a service that they need to provide in March 2024. In this case, they will record the transaction as follows: 

DRG Ltd transactions entries for February 2024

DRG Ltd transactions entries for March 2024

Accrual Accounting vs Cash Accounting : Key Differences 

The key difference between cash accounting and accrual accounting is related to the timing of when the transactions are recorded. While cash accounting records revenues and expenses once actual cash transfer takes place, accrual accounting records revenues or expenses at the time they are earned or incurred. 

The major difference between cash accounting and accrual accounting are:

Benefits of Accrual Accounting

Accrual accounting, by utilizing accruals and deferrals, establishes an accurate, real-time overview of an organization’s financial health and performance. The advantages of the accrual accounting method are as follows:

1. Ensures compliance with accounting standards

   As accrual accounting is the preferred method under GAAP, it enables organizations to be GAAP-compliant. This can help organizations when they undergo audits, also it is seen that investors and lenders might prefer organizations that utilize accrual accounting methods.

2. Provides a more accurate overview of an organization’s financial position

   Accrual accounting combines both current cash flows as well as future or expected cash flows, i.e., it records all financial transactions related to revenue and expenses as they are earned or incurred. Accrual accounting does not depend on whether a cash exchange has taken place. This provides an accurate picture of an organization’s financial health and position, as it provides an overall snapshot of their assets and liabilities. This, in turn, results in more accurate financial statements. 

3. Ease of auditing 

   By recording and tracking all revenue and expense transactions as they occur, accrual accounting makes it easier for auditors to verify transactions and financial statements accuracy. 

4. Ease in financial analysis and proactive decision-making 

   Accrual accounting provides organizations with an actual overview of their financial performance in terms of liquidity and profitability, which aids in financial analysis. Organizations are able to ascertain the cash inflows and outflows, both current and expected, and accordingly take important decisions regarding resource allocation and future investment decisions proactively.

Challenges with Accrual Accounting

Some of the major challenges with accrual accounting are:

1. Accrual accounting is complex as it involves tracking and recording a lot of transactions. It often involves dealing with complex transactions related to deferred revenue and credit-related payments, which demand detailed record-keeping. 
2. Accrual accounting requires dedicated time and effort. As there are many transactions to be tracked, recorded and updated, accrual accounting requires tremendous effort in bookkeeping. Hence there is a need for a dedicated accounting team. 

How Can HighRadius Help in Transforming Your Accounting Processes?

While accrual accounting is complicated and requires extensive efforts in record-keeping, its advantages, especially with respect to accuracy in gauging the financial health of an organization and its compliance with accounting standards such as GAAP, make it extremely important for organizations. To offset its complexity, organizations should leverage accounting software that transforms and automates accounting processes. HighRadius Record to Report (R2R) solutions offer end-to-end capabilities to streamline and automate various accounting processes and workflows. 

From data fetching to journal entry and analysis, HighRadius empowers organizations to achieve a groundbreaking 50% reduction in manual tasks through its no-code platform, LiveCube. Accountants can effortlessly retrieve raw data, perform calculations, and seamlessly upload results into various enterprise systems, streamlining the entire record-keeping workflow.

HighRadius propels organizations towards a 30% faster close, with Journal Entry Management significantly contributing to an accelerated month-end close by offering automated posting options. It further supports reconciliation by automating the posting of adjusted journal entries reducing manual intervention and expediting the close. 

HighRadius R2R solution provides a transformative approach to optimizing accounting processes, ensuring organizations stay ahead in the dynamic landscape of financial management.

FAQs

1) Does GAAP require accrual accounting?

Yes, if an organization needs to be compliant with GAAP, it needs to utilize an accrual accounting method. Further, all publicly listed companies need to follow accrual accounting. Accrual accounting ensures that all the financial statements and reports generated are GAAP-compliant. 

2) How to calculate accrual basis net income?

To calculate accrual basis net income, organizations need to determine the difference between revenue recognized and expenses incurred in that accounting period. The formula to calculate accrual basis net income is (Accrual basis net income = Revenue recognized -Expenses incurred).

3) When is revenue recognized in accrual accounting?

Revenue is recognized in accrual method in the period it is earned, even if the actual cash exchange has yet to take place. This revenue is recognized as accrued revenue and is recorded as accounts receivable. If cash is received but revenue is yet to be earned, it is recorded as deferred revenue. 

4) When are expenses recognized in accrual accounting?

Expenses are recognized in the accrual accounting method for the period in which they are incurred even if it is yet to be paid. The expense is recognized as accrued expense and is recorded as accounts payable. If expense is prepaid, it is recorded as deferred expense or prepaid expense. 

5) What are the advantages of accrual accounting?

The advantages of accrual accounting are that it ensures compliance with accounting standards like GAAP, it helps in auditing, it provides an accurate, comprehensive view of an organization’s financial performance and health, which helps to make data-led, proactive business decisions.