What Is Accrual Accounting? What is Cash Flow: Definition, Examples & How it Works

A straightforward guide to recognizing revenue and expenses when earned or incurred

Now accrual accounting is a type of accounting where we recognize revenue for the services provided to customer(i.e.revenue) and expenses when cash is being used, but not necessarily at the same time. This method, an adaptation of the accrual basis is to get a more accurate picture of a company's financial performance over a reporting period by matching income with related costs in that time frame. This article provides a working accrual accounting definition, straightforward examples and steps to implement the method in practice.

Why accrual accounting matters

The main advantage of accrual accounting is timing. Businesses seldom receive cash or incur costs the same day that they earn revenue or consume resources. Accrual accounting addresses this mismatch by recording transactions upon the financial event taking place, and not merely when cash is exchanged. That makes for more usefulness from financial statements — income statement, balance sheet and cash flow statement — to decision makers, lenders and investors.

Note Book Approach of Accrual approach

Revenue recognition: Recognize revenue when the company has delivered goods or provided services and earned the right to payment. Likewise, revenue recognition is based on when a performance obligation is satisfied; it may not be at the time that payment is accepted.

Expense recognition (matching principle): Expenses are recorded in the same period as revenues they helped to generate. This pairing provides clearer insight into profit margins.

A few important concepts impacted report structure: Earnings Accruals – Accountants make adjusting entries at the end of periods for accrued revenues, accrued expenses, prepaid items and unearned revenue to bring records in line with economic activity.

Simple examples to illustrate

1) For example accrued revenue: A consulting firm performs a project in the month of December but only issues an invoice and bills it at January. In accrual accounting, because the work was performed and the right to collect payment established in December, the firm recognizes the revenue its records that month. So the receivable appears on the December balance sheet, and revenue is recognized on the income statement for December.

2) Accrued expense: A company uses up utility services in March but receives the bill only in April. Using accrual accounting, the utility expense is posted in March when the service was used leading to the posting an accrued liability for the unpaid bill.

3) Unearned revenue: A software company bills customers for its annual subscriptions in advance. When cash is received, it is first recorded as a liability known as unearned revenue. As the months go by and service is rendered, that company takes revenue each month, which naturally decreases the unearned revenue balance.

Accrual accounting versus cash accounting

Cash accounting only records transactions when cash is received, or paid. That approach is easier and commonly used by small businesses and sole proprietors. But cash accounting can distort the timing of income and expenses: a business could seem profitable in months when huge payments arrive and unprofitable in months when bills get paid.

Accrual accounting reflects the reality a lot better about what is going on, because it records the economic events at their moment of occurrence. Accrual accounting, which calculates performance on a more consistent basis, is generally required for larger businesses and for those pursuing external funds.

Examples of typical journal entries in accrual accounting

The accrual accounting method is based on a few journal entries that repeat:

Accounts receivable and revenue: debit accounts receivable, credit sales revenue when a sale is earned but has not yet been paid.

Accounts payable and expenses: Debit expense, credit accounts payable when you incur the expense but haven’t paid yet.

Recognizing prepaid expenses by debiting the expense and crediting prepaid asset as the prepayment is realized.

Recording unearned revenue: Debit unearned revenue, credit revenue when services are performed.

Compliance and reporting considerations

Accrual accounting tends to be more accurate, and thus is preferred (or required) in many accounting standards and tax codes. The approach is consistent with principles of comparable income and expense recognition in financial accounting reporting, ensuring that users have similar (including are able to compare) information regarding finances from period-to-period. For tax and regulatory purposes, businesses that hold inventory or those above certain revenue limits are generally required to use accrual accounting.

Pros and cons

Pros:

Improved reconciliation of revenues and expenses for precise profitability determination.

More helpful financial statements for managers and outsiders.

Not mandatory or used for large companies and official publications.

Cons:

More intricate bookkeeping and more adjustment entries at the end of the period.

Need to keep track of receivables, payables, and other accruals which can be time-consuming.

Can conceal cash flow problems since a company can be profitable but cash poor.

To know how to apply accrual accounting in real life

1) Create clear revenue recognition policies: Clarify when is revenue earned and wheres constraints on performance obligations.

2) Monitor receivables and payables: You should also track invoices sent out and bills received, and then reconcile them.

3) Process adjustment entries: At each reporting period, make an estimate and record accruals for invoices issued for expenses incurred and revenues earned.

4) Track cash flow separately: Because accrual accounting can suggest profits before money actualizes, keep a cash flow forecast to find liquidity.

5) Perform periodic reviews: Agree accrual balances such as accrued expenses and unearned revenue to ensure that they represent legitimate obligations.

Real guidance for small business owners

Get ahead of the game: Make filing invoices and bills a routine so that accrued items are easy to spot.

Carry out month-end procedures: Create a list of top accruals to look after before you can close your books.

Communicate results: When featuring accrual-based reports, explain to stakeholders the difference between profitability and availability of cash.

Conclusion

Accrual accounting is one of the basic methods of accounting, and recognizes revenue and expenses when economic events take place; not by when cash exchanges hands. Accrual accounting provides a clearer and more consistent picture of how a business is performing financially because income and related costs are aligned to the same reporting period. Accrual accounting is vital for businesses in need of accurate, comparable financial information to show management, lenders, and investors; however, it does introduce complexity when compared with cash accounting.