What is accrual accounting

Accrual accounting recognises income and expenses when the underlying transaction occurs, rather than when cash changes hands.

• Revenue is recorded when goods are delivered or services are provided.
• Expenses are recorded when resources are consumed or obligations arise.
• Related revenue and expenses are matched within the same accounting period.
• Accrued revenue refers to income earned but not yet received.
• Accrued expenses refer to costs incurred but not yet paid.
• Deferred revenue is money received before services are delivered.
• Deferred expenses are payments made before the related benefit is used.
   

Accrual accounting is a method of recording revenue when it is earned and expenses when they are incurred, regardless of when the related cash is received or paid. For example, if a business provides a service in March but receives payment in April, the revenue is recorded in March.

This method follows the matching principle, which records related income and expenses in the same accounting period. It helps businesses track receivables, payables, prepaid expenses, and outstanding costs, providing a clearer view of their financial position and performance.

Accrual accounting provides information about income earned, expenses incurred, amounts receivable, and amounts payable. It gives a more complete view of business performance than recording only cash transactions.

Accurate financial reporting

This method records revenues and related expenses in the period in which they occur.

For example, if a business provides a service in March but receives payment in April, the revenue is recorded in March. This ensures that the March financial statements reflect the work completed during that month.

Support for future projections

Accrual accounting helps a business understand:

• The amount it owes to suppliers and service providers
• The amount customers are expected to pay
• Advance payments linked to future obligations
• Prepaid expenses linked to future benefits

This information can support budgeting, cash-flow planning, and the identification of financial trends.

Compliance and transparency

Accrual accounting is commonly used to prepare financial statements under Generally Accepted Accounting Principles, or GAAP.

It is also one of the fundamental accounting assumptions used when preparing books of accounts. Recording transactions in the appropriate period improves consistency and transparency in financial reporting.

The accrual concept requires a business to record income and expenses when the related economic activity occurs. The following steps explain how to apply it.

Step 1: Identify your revenue streams

Start by identifying the different sources from which your business earns income.

Common revenue streams include:

• Sales of goods
• Services rendered
• Interest income
• Royalties

Each source may have different conditions that determine when the income has been earned.

Step 2: Apply the revenue recognition criteria

Revenue should be recognised when it has been earned and is reasonably expected to be collected.

Revenue is considered earned when the business has substantially completed its obligation to the customer. This usually happens when goods are delivered or services are performed.

Revenue is considered realisable when there is a reasonable expectation that the customer will make the payment.

A business should not record revenue only because it expects to make a sale in the future. The earning activity must have already occurred.

Step 3: Identify your expenses

Businesses incur several costs while generating revenue and carrying out their operations.

Common expenses include:

• Cost of goods sold
• Salaries
• Rent
• Utilities
• Depreciation

The payment date does not determine when these expenses are recorded.

Step 4: Apply the expense recognition criteria

An expense is recognised when goods or services are consumed or when an obligation arises.

For example, electricity used in March is recorded as a March expense, even if the bill is paid in April. This allows the cost to be matched with the business activity of the correct period.

Step 5: Record income and expenses

After identifying and recognising income and expenses, record them using double-entry accounting.

Every transaction affects at least two accounts through a debit and a credit.

When revenue is earned on credit:

• Debit accounts receivable or the customer’s account.

• Credit the relevant revenue account.

  
  

When an expense is incurred but not yet paid:

• Debit the relevant expense or purchase account.
• Credit accounts payable or the supplier’s account.

When cash revenue is earned:

• Debit cash or bank.

• Credit the relevant revenue account.

  
  

When an expense is paid immediately:

• Debit the relevant expense account.

• Credit cash or bank.

  
  
  

Accrual journal entries record income and expenses in the period in which they are earned or incurred.

Accrued revenue

Suppose a consulting firm provides services to M/s ABC Ltd. in December but raises the invoice in January.

The revenue is recorded in December because the service was completed during that month.

The journal entry is:

• Debit accounts receivable or the M/s ABC Ltd. account.
• Credit consulting revenue or sales.

When the payment is received, debit cash or bank and credit accounts receivable.

Accrued expenses

Suppose a company receives goods from M/s XYZ Ltd. in October but pays the invoice in December.

The purchase or expense is recorded in October because that is when the goods were received.

The journal entry is:

• Debit purchases, inventory, or the relevant expense account.
• Credit the M/s XYZ Ltd. account or accounts payable.

When the payment is made in December, debit the supplier account and credit cash or bank.

Deferred revenue

Suppose a customer pays in December for a year-long subscription that will be provided over the following year.

Since the service has not yet been delivered, the payment is first recorded as a liability.

When the payment is received:

• Debit cash or bank.
• Credit unearned revenue.

As the service is provided each month:

• Debit unearned revenue.
• Credit subscription revenue.

This ensures that revenue is recorded only when the related service is delivered.

Deferred expenses

Suppose a business pays in December for insurance coverage that applies to the following year.

The initial payment is recorded as a prepaid asset because the insurance benefit has not yet been consumed.

When the payment is made:

• Debit prepaid insurance.
• Credit, cash or bank.

As each month passes:

• Debit insurance expense.
• Credit prepaid insurance.

This spreads the cost over the periods that receive the insurance benefit.

Accrual accounting records revenue and expenses in the periods to which they relate. It does not depend only on when cash enters or leaves a bank account. The accrual concept states that income should be recognised when it is earned and expenses should be recognised when they are incurred. This helps match related income and costs within the same accounting period. By recording receivables, payables, deferred revenue, and prepaid expenses, a business can gain a clearer view of its financial position. It can also prepare financial statements that follow recognised accounting principles and support financial planning.