Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Accrual Accounting

What it is:

Accrual accounting is an accounting method whereby revenue and expenses are recorded in the periods in which they are incurred.

How it works (Example):

Accrual accounting is the opposite of cash accounting, which recognizes economic events only when cash is exchanged.

The accrual method is more common than the cash method, and the IRS often requires companies to use the accrual method when they have more than a certain level of revenues or carry inventory. The techniques, methods, requirements, determinations, and discretion allowed when using the accrual method are governed by Generally Accepted Accounting Principles (GAAP).

As you can see, accrual accounting recognizes economic events in certain periods regardless of when actual cash transactions occur.

For example, let's assume Company XYZ must insure one of its buildings.  The insurance company bills Company XYZ $600 every six months (one bill in January, the next in July). If each bill is for six months of coverage, then under the accrual method, Company XYZ would not record a $600 expense in January and a $600 expense in July (doing so would mean Company XYZ was using the cash method); it would instead record a $100 expense each month for the whole year. That is, Company XYZ would match the expense to the period in which it was incurred: $100 for January, $100 for February, $100 for March, and so on.

Why it Matters:

Although it is more complex, harder to implement, and harder to maintain than the cash method of accounting, most analysts agree that accrual accounting gives a more accurate picture of a company's performance. That's because in any given accounting period, revenues are associated with their corresponding expenses, which gives a truer picture of the real costs of generating revenue in a given period.

Additionally, accrual accounting allows companies to reflect the fact that sales may have been made and expenses incurred even if cash has not changed hands yet (as is often the case with sales made on credit and similar circumstances). This in turn produces financial statements that are comparable over time.

However, one of the big drawbacks of accrual accounting is that it tends to obscure the nature of the company's actual cash position (e.g., a company may show millions in sales but only have $10 in its cash account because its customers haven't paid yet).

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