Accrual Accounting 

What does it mean

Accrual Accounting is one of the two Accounting Methods most commonly seen in the US (the other is Cash Accounting).  The main difference between the two methods is “when” revenue and expenses are recognized on an income statement and balance sheet.  In the case of Accrual Accounting, there are two overarching principals in place.  The first is that Revenue is recognized once it has been “earned” and the second is that expense are “matched” with their corresponding revenue.  

When I say revenue is identified when it is earned, it means that the borrower’s income statement will show revenue at the point they have “earned” the revenue; not necessarily when they collect the cash.  If the borrower provides a good or service and then issues an invoice with repayment terms of Net 30, the revenue is recognized when the invoice is sent (creates an Accounts Receivable), but the cash collection may not actually occur until up to 30 days later.  

The second element is the “matching” principal.  This is actually best described by looking at a scenario as if CASH Accounting was used.  In the cash accounting scenario, we have a coffee roaster business.  The coffee roaster purchased the inputs in December (green coffee, bags, labels, etc).  It then sold the bag of coffee in January, but the invoice didn’t call for payment until Feb 1st, which is ultimately when the payment was actually received.  In a cash accounting scenario (when viewed on a monthly basis with no other transactions happening), the borrower will show a loss in December equal to the cost of the inputs, no income or expense at all in January, and they will show a big profit in February because that is when the cash was received.  In accrual accounting, revenue is recognized when it was earned; so in accrual accounting, the revenue would be shown in January (not February), and then the matching principal will have the costs that went into the revenue “matched” to the same time period as the revenue.  In our case, that means the costs which happened in December, will actually show as an expense in January (matching the same month as revenue).  

Why does it matter

It matters to know your customers accounting method because there is a big difference between accrual and cash accounting.  Overall, accrual accounting is superior at showing the true performance of the company, but the smaller a company gets, the more prevalent cash accounting is because it is easier to do.  Please take a look at the Why Does It Matter in Cash Accounting to learn the risks present in that accounting method.  

One additional thing to remember for accrual accounting is that accrual profit does not necessarily translate into “cash” profit.  The reason is because the profit is recognized once it is “earned.”

Other Relevant Terms

• Capital
• Capacity
• Cash Accounting
• Return to Terminology Library