In day-to-day business operations, payments and expenses do not always happen at the same time as the underlying activity. A business may deliver a service before receiving payment or incur costs before settling the bill. When accounts are maintained only based on cash movement, these timing differences can affect how financial performance is viewed.
To manage this, businesses use an accounting approach that records financial activity in the period in which it takes place. This helps ensure that income and expenses are reflected accurately, supports compliance with accounting requirements, and improves the quality of financial reporting.
This blog explains how accrual accounting works, the principles behind it, and how it is applied using practical examples. It also covers when this method is appropriate, its advantages and limitations, and how it differs from cash accounting in the Indian business context.
What is Accrual Accounting
Accrual accounting is a method of accounting in which income and expenses are recorded when they are earned or incurred, regardless of when the actual cash is received or paid. This approach, also known as accrual basis accounting, records transactions based on occurrence rather than cash movement.
Under the accrual method, revenues are recognised when a product is delivered or a service is completed, even if payment is received later. Similarly, expenses are recorded when the obligation arises, not when the payment is made. This accrual concept in accounting provides a more accurate view of a business’s financial position than cash-based accounting.
Accrual Accounting Example
Suppose a business provided a service in December but only received payment in January. Under the accrual system of accounting, the revenue would be recorded in December, even though the cash was received in January.
Similarly, if a company incurs an expense, such as receiving goods on credit in October but paying for them in November, the expense is recorded in October under accrual accounting.
How Accrual Accounting Works
Accrual accounting works by recording financial transactions at the time the economic activity takes place, instead of when cash moves in or out of the business. This approach focuses on when income is earned and when expenses are incurred.
When a business provides goods or services, the revenue is recorded in the same accounting period, even if the customer pays later. In the same way, expenses are recognised when the business receives goods or services, even if the payment is made at a later date.
To support this system, businesses maintain records such as accounts receivable for income that is yet to be collected and accounts payable for expenses that are yet to be paid. These entries help present a clearer and more complete picture of financial performance for each reporting period.
What is Accrual Assumption in Accounting
The accrual assumption in accounting states that financial transactions should be recorded in the accounting period in which they occur, not when cash is received or paid. This assumption forms the foundation of the accrual system of accounting.
By following the accrual assumption, businesses recognise income when it is earned and expenses when they are incurred. This allows financial statements to present a more accurate and realistic view of a company’s financial performance and obligations for a specific period.
Accrual Accounting Treatment of Electricity Expenses
Electricity expenses under accrual accounting are recorded in the period in which the electricity is consumed, not when the bill is received or paid.
For instance, a business uses electricity throughout the month of March but receives the electricity bill in April and pays it later. Under the accrual system of accounting, the electricity expense is recorded in March because that is when the consumption occurred. This ensures that utility costs are matched with the correct accounting period.
What is Accrued Income?
Accrued income refers to income that has been earned by a business but has not yet been received in cash or recorded as a payment.
For example, a consulting firm completes a project in March but raises the invoice in April. Under accrual accounting, the income is recorded in March as accrued income because the service has already been delivered. Once the payment is received, the accrued income balance is cleared.
Accrued income helps businesses recognise revenue in the correct period and provides a clearer view of expected cash inflows. It is commonly seen in services, interest income, rent receivable, and long-term contracts.
Accrual Accounting Principles
Accrual accounting principles guide how transactions are recorded and ensure accurate financial reports for a company. In this section, you will learn about different principles of accrual accounting:
Revenue Recognition Principle
This accrual accounting principle states that revenue should be recognized when it is earned, not when payment is received.
Matching Principle
This accrual accounting principle states that expenses should be recorded in the same period as revenues when they are generated.
Consistency Principle
According to this accrual accounting principle, businesses should consistently apply the same accounting methods and principles from one period to the next. This helps ensure comparability across periods. This is useful for investors and creditors who rely on financial reports to make informed decisions. Switching between different methods, such as accrual and cash-basis accounting, can distort the company’s financial picture and lead to misleading conclusions about its performance.
Full Disclosure Principle
It states that businesses should provide all relevant financial information in their financial statements that may affect the interpretation of the financial reports while using accrual accounting. For example, if a company has significant outstanding accounts receivable or accounts payable, it must be disclosed to provide a complete picture of its financial position.
When to Use Accrual Accounting
The decision to adopt accrual accounting largely depends on the nature, size, and financial needs of a business. While this accounting method offers many advantages, such as a more comprehensive view of financial health, it may not be suitable for every business.
Learn here when you should use the accrual accounting method:
For Businesses with Complex Transactions
An accrual system of accounting is particularly useful to businesses involved in complex transactions, such as long-term contracts, credit sales, or deferred payments.
For Companies with Regulatory Requirements
An accrual accounting system is compulsory for all public companies and businesses required to follow accounting standards such as IFRS, GAAP, or the Companies Act, 2013 in India, to ensure that financial reporting is consistent and transparent in order to maintain investors’ confidence and regulatory compliance.
For Companies Seeking Accurate Profitability Insights
An accrual system of accounting provides a better indication of a company’s profitability than a cash-based system. It is especially useful for companies with lumpy sales or seasonal revenues; it matches revenue with the costs that contributed to it in the same reporting period.
In India, accrual accounting is mandatory for companies under the Companies Act, 2013, and is widely followed for statutory reporting and audits.
Advantages of Accrual Accounting
The accrual basis of accounting offers several advantages over the cash-based system. Let’s explore the key advantages of accrual accounting.
Accurate Financial Picture
Accrual accounting offers a more accurate and comprehensive picture of a company’s financial health. Financial statements are aligned with the company’s actual business activity by recording revenues when they are earned and expenses when they are incurred. This is particularly important for businesses that operate on credit or have long-term projects.
Improved Financial Planning and Decision-Making
The accrual basis of accounting allows better financial planning and decision-making. This ensures better expense management and more informed decisions about budgeting, investing, and expansion.
Better Matching of Revenue and Expenses
The accrual accounting system ensures that expenses are recorded in the same period as the revenues they generate, leading to a more accurate calculation of profit and loss. This is particularly useful for businesses with seasonal sales cycles or those involved in long-term projects.
Enhanced Credibility with Investors and Lenders
Accrual accounting provides businesses with enhanced credibility when dealing with investors and lenders. This method helps build trust with external stakeholders as it offers a clearer, more accurate representation of the company’s financial health. Investors and lenders are more likely to provide financing to businesses that use accrual accounting, as it gives them confidence that the company’s financial statements are reliable and compliant with accepted accounting standards.
Disadvantages of Accrual Accounting
Although the accrual accounting system is a useful way of recording financial transactions and provides organisations with a more accurate financial picture and a clearer channel to undertake strategic planning and better forecasting, the system does come with some disadvantages. These are as follows:
Complexity
One of the biggest disadvantages of accrual accounting is its complexity. The accrual accounting system requires businesses to track revenues and expenses as they occur, rather than waiting for cash to change hands. This involves maintaining detailed records of receivables (money owed to the company) and payables (money the company owes to others), which can be time-consuming and resource-intensive. Additionally, businesses must account for deferred revenues and expenses, which adds to the complexity.
For small businesses or those with limited accounting expertise, managing these detailed records can be challenging. It often requires the use of accounting software or hiring professional accountants to ensure accurate reporting, which can increase costs.
Impact on Cash Flow Management
Accrual accounting can’t provide a detailed picture of immediate cash flow within a company. Since revenues are recorded when earned and expenses when incurred, businesses might appear profitable on paper but struggle with cash flow in reality. For instance, a company could show significant revenue but have no cash in hand if customers have not yet paid their invoices.
This mismatch between profits and actual cash availability can be problematic for businesses that rely on steady cash flow to meet day-to-day expenses. Companies must monitor their cash flow carefully alongside their accrual-based financial statements to avoid liquidity issues.
Time and Effort Required for Maintenance
The accrual system of accounting requires regular updates and maintenance to keep track of all transactions accurately. Businesses need to consistently monitor outstanding receivables and payables, reconcile accounts, and ensure that revenues and expenses are recorded in the correct periods. This ongoing effort can be burdensome, especially for businesses with high transaction volumes or limited accounting staff.
Additionally, reconciling accrual-based records with cash flow can be complex and may require additional reports to understand the true financial position, increasing the workload for businesses.
Potential for Misleading Financial Statements
While accrual accounting provides a clearer long-term picture of financial performance, it can sometimes present misleading short-term results. For instance, a company that records significant revenues from future projects might appear highly profitable in one quarter, even though those revenues won’t convert into cash for several months. Conversely, a company might show losses if it incurs large expenses upfront, even if the associated revenue will be earned later.
This can make it difficult for business owners, managers, and investors to accurately assess the company’s financial health, particularly if they focus too much on short-term figures rather than the bigger picture.
Although the accrual system of accounting offers more accuracy in financial reporting, its complexity, potential cash flow issues, and time-consuming nature may pose challenges for businesses. It’s essential for companies to weigh these disadvantages carefully when deciding whether the accrual accounting method is the right choice for their financial reporting needs.
Accrual Accounting vs Cash Accounting
Basis of Comparison |
Accrual Accounting |
Cash Accounting |
Timing of revenue recognition |
Revenue is recorded when it is earned, even if payment is received later |
Revenue is recorded only when cash is received |
Timing of expense recognition |
Expenses are recorded when they are incurred, even if payment is made later |
Expenses are recorded only when cash is paid |
Accuracy of financial reporting |
Provides a more clearer view of financial performance and obligations |
May not reflect true financial position if receivables or payables exist |
Complexity |
More complex due to tracking of receivables, payables, and accrual entries |
Simpler and easier to maintain |
Cash flow visibility |
Does not show actual cash position directly |
Shows actual cash inflows and outflows clearly |
Suitability |
Suitable for growing businesses, large companies, and those with credit transactions |
Suitable for small businesses with simple cash flows |
Regulatory compliance |
Required under accounting standards such as IFRS and GAAP |
Not accepted for reporting under most accounting standards |
Conclusion
The accrual system of accounting provides businesses with a comprehensive and accurate view of their financial activities by recording revenues and expenses when they are earned or incurred rather than when cash changes hands. Understanding accrual accounting enables businesses to gain several advantages, including better financial planning, regulatory compliance, and more accurate profitability assessments. For businesses with complex transactions, long-term projects, or credit sales, accrual accounting ensures that financial statements reflect the true economic activity of the business.
However, the accrual accounting method also has its drawbacks, such as increased complexity, time-consuming maintenance, and potential cash flow management challenges. Smaller businesses or those with simpler operations may find that the cash-based system is more manageable, although accrual accounting becomes essential for companies aiming to grow, attract investment, or meet regulatory standards.
Ultimately, the decision to use accrual accounting depends on a company’s size, financial needs, and long-term goals. By understanding both the benefits and challenges of this accounting method, businesses can make informed decisions about how best to manage their finances and plan for future growth.
FAQs
1. What is accrual accounting?
Accrual accounting is a method where revenues and expenses are recognised in the period they occur, regardless of when cash is exchanged. This approach provides a more accurate view of a business’s financial performance.
2. How does accrual accounting affect cash flow management?
Accrual accounting does not track actual cash movement, which can make short-term cash flow management challenging. Businesses often use cash flow statements alongside accrual-based reports to maintain liquidity.
3. What is accrued income?
Accrued income is income that has been earned but not yet received in cash or invoiced. It is recorded in the period in which the service is delivered or income is generated.
4. What are accrual accounting entries?
Accrual accounting entries record revenues or expenses before cash is exchanged. Common examples include recording accrued income, outstanding expenses, accounts receivable, and accounts payable.
5. Is accrual accounting mandatory for all businesses?
Accrual accounting is mandatory for large companies and businesses following accounting standards such as IFRS or GAAP. Small businesses with simple operations may use cash accounting unless regulations require otherwise.
6. Can a business switch from cash accounting to accrual accounting?
Yes, businesses can switch from cash accounting to accrual accounting as they grow. The transition requires adjustments to recognise income and expenses based on occurrence rather than cash flow.
7. How does accrual accounting impact tax filings?
Businesses using accrual accounting calculate taxable income based on income earned and expenses incurred during the period, subject to adjustments prescribed under tax laws.. This can result in tax liability before cash is actually received.
8. What is the difference between accrued income and received income?
Accrued income is earned but not yet received, while received income refers to cash already collected. Accrual accounting records income when it is earned, not when payment is received.
