Definition
Accrual accounting is a method of recording financial transactions based on when they occur economically, rather than when cash changes hands. Income is recognised when it is earned (when the goods are delivered or the service is performed), and expenses are recognised when they are incurred (when the obligation arises), regardless of when payment is actually received or made.
Who Must Use Accrual Accounting?
This is the basis required under Australian Accounting Standards and is the method used by all publicly listed companies, large proprietary companies, and any business that needs to comply with the Australian Financial Reporting Standards (AIFRS). For smaller businesses, it is generally the more accurate method for measuring financial performance.
The Matching Principle in Accrual Accounting
Take a software company that sells a 12-month licence in January for $12,000. Under cash accounting, the full $12,000 is income in January. Under accrual accounting, $1,000 is recognised each month as the service is delivered. This matching principle, pairing revenue with the period in which it is earned, produces more reliable profit and loss statements.
Accruals and Prepayments
Accrual accounting also records expected obligations before cash is paid. If a business incurs electricity costs in December but the bill is not paid until January, December’s profit and loss statement still carries that electricity expense. This prevents a business from looking more profitable simply because it delayed paying its bills.
The method produces two accounting entries that do not appear in cash accounting: accruals and prepayments. An accrual is an expense incurred but not yet invoiced or paid. A prepayment is cash paid in advance for a future expense, recognised as an asset until the service is consumed.
Trade-offs of Accrual Accounting
The trade-off with accrual accounting is complexity. It requires more judgment calls, such as when exactly revenue should be recognised for long-term contracts, and it demands more discipline to reconcile bank accounts against the books. For most growing businesses, though, the clearer financial picture it provides is worth the additional effort.