In business accounting, you may come across the term “accrual.” Basically, this term refers to revenue that has been earned but not yet officially recorded. If you ship a product or service, for instance, you may use accrual accounting to keep track of such revenue. Even if the customer hasn’t paid, you can still record the transaction as an accrual.
Here’s a common example of accrual accounting: a retail sells a product to a customer, and that customer pays using his or her store credit. The customer might not pay for the product for another month (or longer). Nonetheless, the retail store should record the transaction as an accrual. This ensures the transaction is recorded in the appropriate month. If the customer purchases the product on store credit in January but doesn’t pay until February, recording it immediately as an accrual prevents discrepancies.
Accrual account is the opposite of cash accounting. With cash accounting, the business records its income when payment is received from the customer. This doesn’t necessarily have to be a cash payment. Whether the customer pays using cash, credit card, debit card or check, the business records the income earned from the sale at the time of payment.
You might be surprised to learn that some businesses in the United States are actually required to use the accrual accounting method. The Internal Revenue Service (IRS) specifically states that all businesses that earn more than $5 million in gross sales, for instance, must use the accrual accounting method. Businesses meeting this criteria that use the cash accounting method are not complying with the IRS’s rules in this regard.
Of course, there are both pros and cons to using the accrual accounting method. One advantages include the ability to defer some of your tax liability. Additionally, it ensures your business’s income matches its related expenses. On the other hand, accrual accounting ignores cash flow. You record transactions as income even if you don’t receive payment for those transactions. Furthermore, accrual accounting is more laborious and time consuming than cash accounting.
Hopefully, this gives you a better understanding of accrual accounting. To recap, it involves recording revenue after selling a product or service before the customer has paid. While it has some disadvantages (see above), the Financial Accounting Standards Board (FASB) says it’s an excellent way to reveal additional information about a business’s assets, liabilities and earnings.
Have anything else you’d like to add? Let us know in the comments section below!