Accrual-based accounting is a method of accounting for revenues and expenses for a business. Other methods are cash and tax basis. The accrual basis is recognized by the U.S. Generally Accepted Accounting Principles, also known as "GAAP." The accrual basis, used by corporations with inventories and with sales of $5 million or more, provides a reliable way to present financial statements. Many banks and investors require the accrual method of accounting and will not accept financial statements prepared under any other basis.
Under the accrual method of accounting, income is recognized when goods and services are provided—not when you're paid. In practical terms, most accounting software working under accrual basis will book income when an invoice is set up and saved in the system. Financial statements present accounts receivable and other accrual basis items, such as "Deferred Revenue" and "Accrued Revenues".
In accrual, timing matters. A receivable is money that is owed to you; income is booked. Deferred revenue reflects funds that have been received, but if goods and services haven't been provided, income is not recognized. Accrued revenues are for goods and services provided in the period but not yet invoiced and not yet part of the receivables.
Expenses are recognized as they occur under the accrual basis—not when they are paid. For example, utilities are often recognized in the books as "accrued expenses" because the expense is accrued in one month and paid for the following month.
Prepaid expenses are those that have been paid in one period when they cover goods or services to be rendered in the following period. They are not recognized as expenses in the period during which the payment is made. An example is a fee paid for a conference that will happen in the following period. Once the conference happens, then the expense is recognized.
For accrual accounting to be meaningful and provide management with reliable and comparable information, the method must be employed consistently throughout the years. For example, if payroll is accrued every month and at year-end, this should be followed all the time. If you change your methodology from month to month or from year to year, you end up with unreliable numbers that may not be compared.
Following are some typical journal entries involved in the accrual basis:
Journal entry to recognize expense that will be paid in the future and not yet part of your accounts payable:
Debit expense Credit Accrued expense - liability
Journal entry to make when the bill is received and paid the following period:
Debit Accrued expense - liability Credit cash
Journal entry to book deferred revenue for funds received, but goods and services not yet provided:
Debit cash Credit deferred revenue - liability
Journal entry to recognize revenue after goods are services were provided:
Debit deferred revenue - liability Credit revenue
Accrual basis of accounting is more complicated to maintain than cash basis, but it is also much more advantageous when planning and determining how a business is doing financially. Financial statements prepared under the accrual method often present receivables and payables classified under current and long term. If you see that a business has $10 in cash, but a $10,000 in current payables, you may think twice before investing any money to it. Maybe this firm also has $200,000 in current receivables and in that case, you may be willing to invest funds. Accrual basis financial statements not only show how a business is performing now, but also how likely it is to perform in the future.