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The accrual method in accounting

How can the accrual method in accounting improve people, teams, or organisational effectiveness?

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Contents

There are two basic ways of keeping the accounts for a business.

Business accounts can be prepared on a cash basis or an accrual basis. Cash accounting records income and expenditure when money changes hands. Accrual accounting records economic activity when revenue is earned or an expense is incurred, even when the associated cash arrives or leaves later. Small organisations and personal finances often use cash accounting; larger organisations generally require accrual information.

When to use it

Use accrual accounts to understand the economic performance of a business over a reporting period.

Use the distinction to explain why reported profit and cash flow are not the same.

Origins

Accrual accounting developed gradually alongside double-entry bookkeeping, periodic reporting and long-lived business organisations. Luca Pacioli’s 1494 description of Venetian bookkeeping is an important milestone in the documentation of double entry, though not a single invention of the modern accrual method. The Dutch East India Company, chartered in 1602, helped create a need for accounts covering continuing operations rather than one self-contained voyage at a time. Periodic measurement, asset valuation and the matching of revenues with related expenses evolved through later accounting practice and standards.

What it is

Accrual accounting recognises a transaction according to the underlying activity. Revenue is recorded when it is earned and expenses when resources are consumed or obligations arise, subject to the applicable accounting rules. Cash may be collected or paid in another period.

Cash accounting is simpler: a purchase appears when payment is made and a sale when cash is received. That timing can obscure operating performance. Accrual accounting instead creates receivables for earned but uncollected revenue, payables for obligations not yet paid, inventory for resources not yet consumed and depreciation for the use of long-lived assets.

Matching activity to the appropriate period helps managers assess margins, collection performance and use of supplier credit. It also means that a profitable business can face a cash shortage, or that strong cash receipts can coexist with weak underlying performance.

How to use it

Map the complete operating cycle from purchasing and production through sale, invoicing and cash collection. When goods or services are delivered and the recognition criteria are met, record the revenue and the associated costs in the relevant period. If the customer has not paid, recognise a receivable and track its eventual collection.

Record supplier obligations when goods or services are received rather than waiting for payment. Use payment windows and legitimate discounts without confusing delayed cash outflow with lower expense. At each reporting date, review estimates and adjustments such as accrued expenses, deferred revenue, doubtful debts, inventory and depreciation.

Compare the income statement with the cash-flow statement and balance sheet. Profitability shows whether activity created an accounting return; cash-flow analysis shows whether the organisation can fund operations and meet obligations. Reconcile the two rather than expecting them to coincide.

Top practical tip

When reviewing a small firm, establish whether its statements use cash or accrual accounting before comparing periods, margins or businesses.

Top pitfall

Accruals require estimates and recognition judgements. Poor cut-offs or aggressive assumptions can misstate performance, so material entries need evidence and qualified review.