Accrual: Overview, definition, and example
What is accrual?
Accrual refers to the recognition of financial transactions in the accounting records when they occur, regardless of when the actual cash flow takes place. In an accrual accounting system, revenue and expenses are recorded when they are earned or incurred, not when the cash is received or paid. This method ensures that financial statements reflect the true financial position of an organization at any given point in time, providing a more accurate picture of the company's financial performance.
For example, if a company provides services to a client in December but receives payment in January, the revenue is recorded in December under accrual accounting, when the service was completed, rather than when the cash was received.
Why is accrual important?
Accrual is important because it provides a more accurate and complete view of an organization's financial health. By recognizing revenue and expenses when they occur, accrual accounting aligns the financial reporting with the actual economic activities of the business. This is especially critical for businesses that provide services over time or engage in credit transactions. Accrual accounting helps businesses plan for future cash flows, manage long-term projects, and maintain transparency with investors, creditors, and stakeholders.
Understanding accrual through an example
Let’s say a consulting firm completes a project for a client in June but does not receive payment until August. Under accrual accounting, the firm will recognize the revenue from the project in June, the month when the work was completed, rather than waiting until August when the cash is actually received. This ensures that the firm’s financial statements for June accurately reflect the revenue earned from the project, even though the cash has not yet been received.
In another example, a company incurs $1,000 in utility expenses in December, but the payment is not due until January. Under accrual accounting, the expense will be recognized in December, when the utility services were used, and not in January, when the payment is made.
An example of an accrual clause
Here’s how an accrual clause might appear in an accounting agreement or financial statement:
“Revenue from services rendered shall be recognized in the month when the service is provided, and expenses will be recognized when incurred, regardless of when cash transactions take place, in accordance with the accrual accounting method.”
Conclusion
Accrual accounting plays a crucial role in providing a clear and accurate picture of a company's financial performance by recording transactions when they occur, not when cash is exchanged. This method is particularly valuable for businesses with long-term projects, credit transactions, or complex revenue streams, helping ensure that financial statements accurately reflect the true economic activity of the business. Understanding accruals is essential for managing finances, making informed decisions, and maintaining transparency with stakeholders.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.