Why accrual accounting exists

Two timelines

Accounting keeps track of two timelines at once. The first is the business's economic activity: the work it does for customers and the resources it uses up to do that work. The second is its cash: money coming in and going out.

Sometimes the two line up. A coffee shop sells a coffee and is paid on the spot. Often they don't. A consultant finishes a project in December and is paid in January. An employee works in December and is paid on the first payday of January. A company pays a year of insurance in advance and uses it up month by month.

The question is which timeline should decide when a period's results are reported. Accrual accounting chooses the first. Revenue is recorded when it is earned and expenses when they are incurred, whether or not cash has changed hands. Under US GAAP, revenue is earned when the business satisfies its promise to the customer: ASC 606-10-25-23 says revenue is recognized when (or as) the business transfers the promised good or service, which happens when the customer obtains control of it. An expense is incurred when the business uses up the resource, such as the employee's hours.

The reason is in the FASB's statement of what financial reporting is for. Concepts Statement No. 8, paragraph OB17, says accrual accounting depicts the effects of transactions in the periods in which those effects occur, even if the cash arrives or leaves in a different period, because that gives a better basis for judging how the business performed than its cash receipts and payments alone. Put simply, a month's results should reflect the month's work, not when the month's bills happened to be paid.

A worked example: one job, two months

This example is hypothetical. Ridgeline Consulting does one $10,000 job, finished in December. The customer pays the invoice in January. Ridgeline's one employee does $5,000 of work on the job in December and is paid in January. To keep the arithmetic visible, Ridgeline does no other work in either month.

In December, accrual accounting records the revenue, with a receivable for the amount the customer owes:

Account	Debit	Credit
Accounts receivable	$10,000
Service revenue		$10,000
Totals	$10,000	$10,000

Revenue is recorded when the work is done. No cash account appears.

It also records the wage expense, with a payable for the amount Ridgeline owes its employee:

Account	Debit	Credit
Wage expense	$5,000
Wages payable		$5,000
Totals	$5,000	$5,000

The expense is recorded when the work is done. The payable is the obligation to pay later.

1. Revenue earned in December$10,000
2. −Wages incurred in December$5,000
3. =December net income$5,000

Net income for December, in dollars. No cash moved in December, and the figure does not depend on that.

Revenue earned

Revenue for work the business completed for customers in the period, in dollars, whether or not the customer has paid.

Expenses incurred

Costs of resources the business used up in the period, in dollars, whether or not it has paid for them.

In January, the cash moves. Neither entry records revenue or expense. Each one settles a receivable or a payable that December created:

Account	Debit	Credit
Cash	$10,000
Accounts receivable		$10,000
Totals	$10,000	$10,000

One asset becomes another. No revenue is recorded.

Account	Debit	Credit
Wages payable	$5,000
Cash		$5,000
Totals	$5,000	$5,000

The obligation is settled. No expense is recorded.

Now compare the two months, measured both ways:

Both methods arrive at $5,000 over the two months. What differs is which month gets it. On the accrual basis, December, the month the work was done, shows the $5,000. On the cash basis, December shows nothing, and January, a month in which Ridgeline did no work at all, shows the whole result.

1. 1December: the consulting job is finished

   Economic activity (what accrual records)

   Revenue of $10,000 is earned. The customer now owes $10,000.

   Cash movement

   Nothing. The invoice is unpaid.

2. 2December: the employee works

   Economic activity (what accrual records)

   Wage expense of $5,000 is incurred. Ridgeline now owes $5,000.

   Cash movement

   Nothing. Payday is in January.

3. 3January: the customer pays

   Economic activity (what accrual records)

   Nothing new. The revenue belongs to December.

   Cash movement

   Rises by $10,000.

4. 4January: the employee is paid

   Economic activity (what accrual records)

   Nothing new. The expense belongs to December.

   Cash movement

   Falls by $5,000.

All of the activity is in December. All of the cash is in January.

The cash basis can do worse than delay a result. Change one fact: suppose Ridgeline paid its employee in December, and the customer still paid in January. The cash basis would then report December as −$5,000 (nothing received, $5,000 paid) and January as +$10,000. Neither month's figure describes that month. The accrual figures do not change at all: $5,000 in December and $0 in January, because the work and its cost both happened in December.

What accrual accounting adds to the balance sheet

At December 31, the accrual records also show what the cash records leave out:

• Accounts receivable of $10,000: an asset, the customer's obligation to pay.
• Wages payable of $5,000: a liability, Ridgeline's obligation to pay its employee.

Those are real rights and obligations at December 31. Assets rose by $10,000 and liabilities by $5,000, so equity rose by the $5,000 of December net income, and the accounting equation still balances. A cash-only record shows none of this. A reader of Ridgeline's cash-basis December would not know that $10,000 is on its way in or that $5,000 is owed.

A common misconception

The usual version is: accrual accounting makes profit look better than it really is, so cash is the more honest number. The example shows why that is not the right comparison. Over the two months, both methods report the same $5,000. Accrual accounting does not create profit. It decides which period the profit belongs to.

Cash is honest about something different: how much money moved. That matters, which is why financial statements include a statement of cash flows alongside the income statement. Concepts Statement No. 8, paragraph OB20, gives cash flow information its own role, including judging liquidity and solvency. The consequence for a reader is the subject of Profit is not cash: a period can be profitable on the accrual basis and still lower the bank balance.

Where this stops

Accrual accounting needs judgment, and cash accounting mostly does not. To record a receivable, a business has to decide when it has earned the revenue, and later whether the customer will in fact pay. To record many expenses, it has to estimate amounts before the bills arrive. Those judgments are why the rules in ASC 606 and elsewhere in US GAAP are detailed. This page states the principle, not those rules.

Not every report uses the accrual basis. Many small businesses keep cash-basis books, and US federal income tax allows the cash method for many taxpayers. The tax rules have their own limits. Under 26 U.S.C. § 448, C corporations and partnerships with a C corporation partner may use the cash method only if their average annual gross receipts over the prior three years do not exceed a threshold of $25 million, adjusted for inflation for years after 2018. Tax accounting methods answer a different question from financial statements, so the two need not match.

This page describes US GAAP. It does not quote IFRS, so readers who need the IFRS wording should read it in the IFRS standards.