Skip to main content
← Back to A Definitions

Accrue: definition, how it works, and 2 main types of accruals

Accrue: Definition, How It Works, and 2 Main Types of Accruals

To accrue means to accumulate or grow over time, particularly in financial accounting, where it refers to the recognition of revenues when earned and expenses when incurred, regardless of when the corresponding cash is received or paid. This concept is fundamental to the accrual basis of accounting, a core component of financial accounting. It aims to provide a more accurate picture of a company's financial performance and position by aligning economic events with the periods in which they occur.

When a company accrues revenue, it means the revenue has been earned, typically because a good or service has been delivered, even if payment has not yet been collected. Similarly, when expenses accrue, they have been incurred in the process of generating revenue, even if the cash outlay has not yet happened. This method stands in contrast to cash basis accounting, which records transactions only when cash changes hands.

History and Origin

The evolution of accounting practices, including the principle to accrue, is deeply rooted in the increasing complexity of commerce and the need for more sophisticated financial reporting. Early forms of accounting date back thousands of years to ancient civilizations in Mesopotamia, where records of expenditures and goods traded were kept. The advent of double-entry bookkeeping, widely attributed to Luca Pacioli in 15th-century Italy, laid the groundwork for modern accounting by formalizing the recording of debits and credits.7

As businesses grew in scale and scope, particularly with the rise of credit transactions and long-term projects, the cash basis of accounting became insufficient. It failed to reflect a company's true economic activity or its financial obligations and entitlements at a given point in time. The need to match revenue with the expenses incurred to generate that revenue led to the formalization of the accrual method. This method allows businesses to represent their financial health more accurately, moving beyond mere cash movements to encompass all economic events.

Key Takeaways

Formula and Calculation

While there isn't a single universal "accrual formula," the concept of accrual accounting revolves around the fundamental accounting equation:

Assets=Liabilities+Equity\text{Assets} = \text{Liabilities} + \text{Equity}

Under accrual accounting, transactions are recorded to reflect their economic impact on asset, liability, and equity accounts when they occur, even if cash hasn't exchanged hands. For example, recognizing accrued revenue means increasing Accounts Receivable (an asset) and Revenue, while accruing an expense increases an Expense account and Accounts Payable (a liability). This adherence to the matching principle ensures that revenues are matched with the expenses that generated them in the same accounting period.

Interpreting the Accrue

Interpreting financial data prepared using accrual accounting provides a more complete understanding of a company's operational performance and financial standing. When you see an accrued revenue, it indicates a sale has been made or service rendered, contributing to the company's profitability, even if the cash has yet to be collected. This shows the true earning capacity of the business during a period. Conversely, accrued expenses reveal the costs incurred to generate that revenue, offering a clear picture of the company's obligations.

This method allows for better analysis of trends, profitability margins, and overall financial health. For instance, a high level of accounts receivable might indicate strong sales but also potential future cash flow issues if collections are slow. Similarly, significant accrued expenses show ongoing obligations that will eventually require cash outflows. Understanding these accruals is crucial for stakeholders to assess a company's solvency and long-term viability, providing context beyond simple cash transactions.

Hypothetical Example

Imagine "Tech Innovations Inc." provides software development services. On December 20, 2024, they complete a project for a client, "Global Enterprises," and invoice them $10,000 for the services. The payment terms state that Global Enterprises will pay within 30 days.

Under accrual accounting, Tech Innovations Inc. would recognize the $10,000 as revenue on December 20, 2024, because the service has been rendered and the revenue earned, even though the cash has not yet been received. The journal entry would be:

  • Debit: Accounts Receivable $10,000
  • Credit: Service Revenue $10,000

This entry increases an asset, accounts receivable, and increases revenue on the income statement for December. When Global Enterprises pays the invoice on January 15, 2025, Tech Innovations Inc. would make another entry:

  • Debit: Cash $10,000
  • Credit: Accounts Receivable $10,000

This second entry reflects the receipt of cash and decreases accounts receivable, but it does not affect the revenue already recognized in December. This process ensures that the revenue is recorded in the period when the work was done, offering a clear picture of performance for that specific period.

Practical Applications

The concept to accrue is widely applied across various aspects of finance and business. In corporate finance, it is essential for preparing transparent financial statements that comply with regulatory standards like GAAP and IFRS. Publicly traded companies, in particular, are typically required to use the accrual method to present their financial position and performance to investors and creditors.

The Internal Revenue Service (IRS) generally mandates that larger businesses and those maintaining inventories use an accrual method for tax purposes, as outlined in IRS Publication 538, Accounting Periods and Methods.6 This ensures that taxable income accurately reflects economic activity rather than just cash movements. Governments and public sector entities also increasingly adopt accrual accounting to gain a more comprehensive view of their assets, liabilities, and financial commitments beyond immediate cash flows.5 The Financial Accounting Standards Board (FASB) formally defines the ten elements of financial statements, including assets, liabilities, and revenues, which are integral to the accrual framework in its Statement of Financial Accounting Concepts No. 6.4

Limitations and Criticisms

While accrual accounting offers a more complete financial picture, it does have limitations. One primary criticism is its complexity compared to cash accounting, which can be more expensive and resource-intensive to implement and maintain.3 This complexity can also make the financial statements less intuitive for non-accounting professionals to interpret, potentially leading to misunderstandings about a business's true cash position.2

A notable drawback is the potential for a mismatch between reported profitability and actual cash flow. A company might show significant accrued revenue and profit on its income statement, but if customers are slow to pay their accounts receivable, the company could face a cash shortage. Conversely, high accrued expenses might indicate future cash outflows that could strain liquidity. Academic literature also highlights challenges, particularly in the public sector, where the adoption of accrual accounting has sometimes met resistance due to its complexity and the potential for accounting information to become more abstract for citizens and politicians.1 This can impact organizational structures and accountability.

Accrue vs. Cash Accounting

The fundamental difference between recognizing a transaction as it accrues and recording it under cash accounting lies in the timing of recognition.

FeatureAccrue (Accrual Accounting)Cash Accounting
Revenue TimingRecognized when earned (service rendered, goods delivered), regardless of cash receipt.Recognized when cash is received.
Expense TimingRecognized when incurred (resources used), regardless of cash payment.Recognized when cash is paid.
Financial PictureProvides a more accurate and comprehensive view of a company's financial performance over a period, reflecting economic reality.Provides a snapshot of cash inflows and outflows, but may not reflect true profitability or obligations.
Balance SheetIncludes non-cash items like accounts receivable and accounts payable.Generally does not track these non-cash assets and liabilities.
ComplianceRequired by GAAP and IFRS for most larger businesses and public companies.Simpler, often used by small businesses or individuals not dealing with complex transactions.

The accrual method, by matching revenues and expenses to the period they relate to, gives a clearer insight into the operational efficiency and profitability of a business, whereas the cash method is straightforward for tracking immediate cash movements.

FAQs

1. What is the main purpose of accrual accounting?

The main purpose of accrual accounting is to match revenues and expenses to the accounting period in which they are earned or incurred, providing a more accurate representation of a company's financial performance and position over time, rather than just tracking cash flows.

2. What are the two main types of accruals?

The two main types of accruals are:

  • Accrued Revenues (or Accrued Income): Revenues that have been earned but for which cash has not yet been received. This often results in an increase in accounts receivable.
  • Accrued Expenses (or Accrued Liabilities): Expenses that have been incurred but for which cash has not yet been paid. This typically results in an increase in accounts payable or other accrued liabilities.

3. Why is accrual accounting preferred over cash accounting for most businesses?

Accrual accounting is generally preferred because it provides a more complete and realistic picture of a company's financial health. It aligns with the matching principle, which helps users understand the true profitability and obligations of a business, regardless of when cash physically exchanges hands. This is crucial for making informed investment and credit decisions.

4. Does accrual accounting affect a company's cash flow?

Accrual accounting directly impacts how financial performance is reported on the income statement and balance sheet, but it does not directly change the actual physical movement of cash. A separate document, the cash flow statement, reconciles the differences between net income (from accrual accounting) and actual cash generated or used by the business.