Ever sent an invoice and waited weeks for payment? Or did you pay for something today that you won’t get until next month? If so, you’ve already experienced accrual accounting in action—even if you didn’t realize it.
Accrual accounting is the system that tracks money when it’s earned or owed—not when it moves. It’s how most companies, especially larger ones, keep their books because it gives a more realistic financial picture than just tracking cash flow.
But why does it matter? If you run a business (or plan to), you need to know whether you’re truly making money or just surviving off timing mismatches. So, let’s break it down in simple terms without the dry textbook feel.
Table of Contents
What is accrual accounting?
Types of accruals
1. Accrued revenues
2. Accrued expenses
Why accrual accounting is a game-changer
1. Financial insight
2. Long-term contract management
3. Credit transaction tracking
4. Investors and lenders prefer it
Challenges of accrual accounting
1. It’s more work
2. Extra personnel training
3. Cost
Other types of accounting methods
1. Cash accounting
2. Hybrid accounting
Accrual accounting vs. cash accounting
Bottom line
What is accrual accounting?
Accrual accounting records income when businesses make a sale or provide a service, even if the payment has yet to arrive. It also tracks expenses when they occur, not just when paid. This approach helps businesses understand their financial health by matching income with the costs needed to earn it all within the same reporting period.
Fun fact: Did you know the U.S. requires every business that earns US $25 million or more over three years to use accrual accounting? However, smaller companies can still use it if they’d want to.
Types of accruals
Under this method, there are two main types of accruals to watch: accrued revenues and accrued expenses. These are important for closing the books at the end of a period in accrual accounting. Here’s a closer look at each one:
1. Accrued revenues
Accrued revenues are earnings a company has made but hasn’t received payment for yet. This happens when a business provides goods or services on credit. Another example is accrued capital expenses—when a company gets equipment or property but hasn’t paid for it yet.
A good example of accrued revenue is electricity usage. An electricity company supplies power to customers before generating revenue. Even though it has ongoing expenses, it does not receive payment until the end of the month.
However, the electricity company must still recognize its expected future income. That’s where accrual accounting comes in—it can keep a more accurate record of its financial situation. So, when the payments finally come in, the business’s cash account increases while its receivables decrease.
2. Accrued expenses
On the other hand, accrued expenses happen when a company buys something on credit and records it as money it owes in its financial records. This means the business has used a service or received goods but hasn’t paid for them yet. Some common examples of accrued expenses include:
- Interest expense accruals: Interest that a company owes but hasn’t paid yet.
- Supplier accruals: Bills from suppliers for goods or services the company has received but not yet paid for.
- Wage or salary accruals: Employee wages for work already done but not paid in full.
Prepaid expenses vs. accrued expenses
Prepaid expenses are the opposite of accrued expenses. Instead of paying later, a company pays in advance for goods or services, even if it doesn’t receive everything immediately.
Why accrual accounting is crucial for businesses
1. Financial insight
Accrual accounting helps businesses see their real costs and profits by matching expenses to their revenue. This makes budgeting, forecasting, and planning more accurate. It also allows businesses to check their performance without being misled by cash flow timing differences.
2. Long-term contract management
Businesses with long-term contracts will need accrual accounting. This method ensures that they record income and expenses according to the contract, making it easier to accurately track a project’s financial progress.
3. Credit transaction tracking
Companies that buy or sell on credit (i.e., receiving or delivering goods and services before payment) can also benefit from accrual accounting because it helps them track money owed and payments due. This strategy makes planning cash flow easier and ensures they have enough funds to keep operations running smoothly.
4. Investors and lenders prefer it
Investors, lenders, and other stakeholders need accurate financial reports to make smart decisions. Thankfully, accrual accounting gives them a clearer picture of a company’s financial health and how well owners manage it.
Challenges of accrual accounting
It’s not all sunshine and profit tracking. There are downsides to accrual accounting—here are some of them:
1. It’s more work
Accrual accounting can be more complex because businesses must track what others owe them (receivables) and the money they owe (payables). For this reason, they will need reliable systems and clear policies to keep records accurate, ensuring they match income and expenses.
2. Extra personnel training
Accrual accounting needs experienced accountants if businesses want their records to be accurate. For this reason, they may need to cover extra training and higher staffing costs to ensure the personnel does everything correctly.
3. Cost
Accrual accounting is not a cheap method. It can be more expensive than cash accounting because it requires advanced software and may lead to higher costs for audits and compliance. However, its more accurate financial picture makes up for this higher expense.
Other types of accounting methods
Businesses usually follow one of three accounting methods (accrual, cash, or hybrid accounting):
1. Cash accounting
Cash accounting records transactions only when money moves in or out. Businesses record their income and expenses only when they receive payments. This method is simple but misleading, as brands may appear profitable one month and lose money the next.
This method is also popular with small businesses and individuals (such as freelancers) because it offers a clear, real-time view of the available cash.
2. Hybrid accounting
Hybrid accounting combines both methods, letting businesses track everyday transactions using cash accounting and larger or more significant items using accrual accounting. This flexible approach helps keep financial records accurate.
This method is also great for small businesses that want to keep daily transactions simple while tracking bigger finances like unpaid invoices, bills, or inventory. However, brands must be extra careful with hybrid accounting to avoid going against tax and accounting regulations.
Accrual accounting vs. cash accounting
Which is better? It depends on how you do business. Let’s compare.
| Feature | Accrual Accounting | Cash Accounting |
| When income is recorded | When the business earns it (even if unpaid) | When the business receives the cash |
| When expenses are recorded | When they’re incurred (even if unpaid) | When the brand pays the cash |
| Accuracy | It gives a more accurate picture of financial health | This method can be misleading |
| Complexity | This method will require tracking receivables or payables | It’s easier to maintain |
| Best for | Businesses dealing with credit or contracts | Simple businesses with few transactions |
Example: A catering company books a big event in December but will not be paid until January. Under accrual accounting, that income is recorded in December, aligning it with the work done. Under cash accounting, it would not appear until January.
Bottom line
Accrual accounting may quickly become necessary if you’re serious about growing a business. Yes, it’s more complex than cash accounting, but it provides real insights, helps with financial planning, and keeps investors, lenders, and regulators happy.
While cash accounting might work for small businesses, it won’t cut it if they’re scaling, managing credit sales, or planning long-term growth—that’s why accrual accounting is their best bet. Thinking about switching? Start by learning the basics, investing in good software, and consulting an accountant to help with the transition.
