ACCRUAL ACCOUNTING

Definition

Accrual accounting is an accounting method in which revenues and expenses are recorded when they are earned or incurred, regardless of when cash is received or paid. This approach contrasts with cash accounting, where transactions are recorded only when cash changes hands.

It is the standard accounting method under GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards) for most medium and large organizations.

Origins

The concept was popularized and formalized in the 15th century by Luca Pacioli, the father of double-entry bookkeeping, which is the foundation of accrual accounting. The method evolved to better match income and expenses to the correct accounting periods for more accurate financial reporting.

Usage

Accrual accounting is used in:

• Financial reporting: Complies with GAAP/IFRS for external audits and investor transparency.

• Tax reporting (for larger entities): Required for businesses over certain revenue thresholds.

• Revenue recognition: Key for companies with long sales or delivery cycles (e.g., software, manufacturing).

• Financial modeling and forecasting: Provides more accurate inputs than cash-based metrics.

   

How Accrual Accounting Works

Accrual accounting follows the matching principle and revenue recognition principle:

• Matching Principle: Expenses are recorded in the same period as the revenues they help generate.

• Revenue Recognition Principle: Revenue is recognized when it is earned and realizable, not necessarily when cash is received.

Examples:

• A business performs a service in December but receives payment in January. Under accrual accounting, revenue is recorded in December.

• A company receives an electricity bill in March but pays it in April. The expense is recorded in March.

Key Takeaway

• Revenue and expenses are recorded when earned or incurred, not when paid.

• Provides a more accurate and complete view of financial health than cash accounting.

• Enables better matching of income and expenses, aiding performance analysis.

• Required under GAAP and IFRS for most corporations.

Types & Variations

1. Accrued Revenues (Accruals)

• Revenues earned but not yet billed or received.

• Example: Interest income earned but not yet received.

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2. Accrued Expenses (Accruals)

• Expenses incurred but not yet paid.

• Example: Salaries payable, utilities used but not yet billed.
  
  

3. Deferred Revenues (Deferrals)

• Cash received before the revenue is earned.

• Example: A subscription payment received in advance.
  
  

4. Prepaid Expenses (Deferrals)

• Expenses paid in advance but not yet incurred.

• Example: Prepaid insurance or rent.

Context in Financial Modeling

Accrual accounting affects:

• Revenue & Expense Timing: Models based on accrual metrics better reflect economic reality.

• Working Capital Components:

  • Accounts receivable → increases revenue before cash inflow.

  • Accounts payable → delays cash outflows from expenses.

• EBIT and EBITDA calculations rely on accrual figures.

   

Nuances & Complexities

• Revenue Timing: Determining when revenue is "earned" can be complex (e.g., long-term contracts).

• Estimates Required: Some accruals (like bad debt or depreciation) require judgment.

• Not Cash-Based: Strong accrual profits may still coincide with poor cash flow.

• Compliance Required: Misapplication can lead to misstated financials and regulatory penalties.

Mathematical Formulas

1. Accrued Revenue Entry:

Dr. Accounts Receivable 
Cr. Revenue

2. Accrued Expense Entry:

Dr. Expense 
Cr. Accounts Payable (or Accrued Liabilities)

3. Adjusted Net Income (Indirect Cash Flow Method):

$$\text{Cash Flow from Ops} = \text{Net Income} + \text{Non-Cash Expenses} + \text{Changes in Working Capital}$$

Related Terms

• Cash Accounting
  
  

•  Matching Principle
  
  

• Revenue Recognition
  
  

• Accounts Receivable/Payable
  
  

• Deferred Revenue
  
  

• GAAP / IFRS

Real-World Applications

Example 1: SaaS Company

A software firm sells annual subscriptions and receives payment upfront. Under accrual accounting, revenue is recognized monthly over the contract term, not at the time of payment.

Example 2: Construction Industry

Revenue from a multi-year project is recognized based on progress (e.g., % of completion), not when cash is received.

Example 3: Payroll Accrual

A company with one-time restructuring costs adds them back to present adjusted EBITDA for a more accurate picture of recurring profitability.

References & Sources

• Investopedia: Accrual Accounting, and How Does It Work?