What Are Accruals? How Accrual Accounting Works

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Accruals are revenues a business has earned and expenses it has incurred that have not yet been paid in cash. Under accrual accounting, a company records them in the period the underlying economic event happens (the work is performed, the goods are delivered, the service is used), not when money changes hands. Both US GAAP and IFRS require this treatment, so the statements show what a business earned and spent in a period, not just what moved through its bank account.

How Accruals Work

Accrual accounting rests on two principles. The revenue recognition principle says revenue is recorded when it is earned. The matching principle says expenses are recorded in the same period as the revenue they helped produce. Accruals are the entries that make both principles work when cash arrives early or late.

Every accrual uses double-entry bookkeeping, so each one has a debit and a matching credit:

• Revenue earned but not yet collected: debit accounts receivable (a balance sheet asset), credit revenue (on the income statement). Both revenue and receivables rise.
• Expense incurred but not yet paid: debit the expense account, credit accrued liabilities or accounts payable. Both expenses and short-term obligations rise.

When the cash finally moves, a second entry clears the balance sheet account. A customer payment debits cash and credits accounts receivable; paying a bill debits the liability and credits cash. The income statement is not touched again, because the revenue or expense was already recognized.

Many accruals are booked as adjusting entries at the end of a month, fiscal quarter or year, for items earned or used but not yet billed. A year-end accrual estimates a cost or income that belongs to the year just ending but will be invoiced or paid in the next. Companies often post a reversing entry on the first day of the new period so the actual invoice can be recorded normally without double counting.

Types of Accruals

Strictly speaking, accruals cover cash that comes after the event. Accounting courses usually group them with deferrals, where cash comes before the event, because both use adjusting entries to move amounts into the right period.

Accrued expenses

Also called accrued liabilities, these are costs incurred but unpaid at period end. Electricity used in October may not be billed until November and paid in December. Wages for the last days of a period, interest building on a loan or semiannual bond, current-year income taxes and bonuses paid after year end also fall here.

Accrued revenue

Also called accrued income, this is revenue earned but not yet billed or collected, such as a sale on credit, consulting hours not yet invoiced or deposit interest that pays out later. It is recorded as a receivable, an asset.

Prepaid expenses

A prepaid expense is cash paid before the benefit is used, such as annual insurance, rent paid in advance or a retainer for a lawyer. The payment is recorded as an asset, then expensed gradually as the coverage or service is consumed.

Deferred revenue

Deferred (unearned) revenue is cash received before the company delivers. Subscriptions billed in advance and orders paid before shipping are common examples. The cash creates a liability, because the company still owes the customer something, and it moves into revenue as the obligation is fulfilled.

Accrual vs. Cash Accounting

Cash accounting records revenue only when payment is received and expenses only when they are paid. It is simpler and tracks the bank balance, which is why many sole proprietors and small firms use it. For US tax purposes, Internal Revenue Code Section 448 generally bars C corporations and partnerships with C corporation partners from the cash method unless they meet a small-business gross receipts test.

Cash accounting trades accuracy for simplicity. A firm that collects a customer payment in December but pays the related costs in January looks more profitable in December than it was, and less profitable in January. Accrual accounting removes that distortion but introduces estimates and judgment.

Accrual Method Example

Hypothetical example. A consulting firm closes its books on December 31. During December:

1. It completes $12,000 of client work, invoiced and paid in January.
2. It uses $800 of electricity, billed in January.
3. On December 1 it pays $2,400 for 12 months of insurance.
4. On December 1 a client prepays $6,000 for six months of service; one month is delivered in December.

Assume nothing else happened in the month.

On the accrual balance sheet, the firm also shows a $12,000 receivable, an $800 accrued liability, a $2,200 prepaid insurance asset and $5,000 of deferred revenue. The cash column describes the bank account; the accrual column describes the work done.

Interpreting Accruals: The Accrual Ratio

Because accrual profit and cash flow can diverge, analysts measure the gap. A common cash flow statement version is:

Total accruals = Net income − Cash flow from operations

Scaling this by average total assets gives an accrual ratio comparable across companies of different size. A large positive figure means earnings are running well ahead of cash, often from growing receivables or shrinking liabilities. Fast-growing companies naturally build receivables, so this is not proof of a problem, but cash-backed earnings are treated as higher quality. Comparing net income with free cash flow applies the same logic.

Limitations of Accruals

• Estimates and judgment. Accruals such as bonuses, warranty costs or unbilled revenue are estimates that may need later correction.
• Room for manipulation. Accelerating revenue recognition or under-accruing expenses can inflate profit, and complex accruals with long settlement horizons are hard for outsiders to verify.
• Profit is not cash. A company can report strong earnings while running short of cash if customers pay slowly, so read the cash flow statement alongside the income statement.
• More work. Tracking receivables, payables, prepaids and deferrals takes more bookkeeping than recording cash in and out.

Accruals vs. Related Terms

• Accrual vs. accrued: an accrual is the entry or the amount; “accrued” describes something that has built up over time but is not yet paid, as in accrued interest or accrued salaries.
• Accrued expenses vs. accounts payable: both are unpaid costs. Accounts payable usually covers bills a supplier has already invoiced; accrued expenses typically cover costs incurred but not yet invoiced, like wages for the last days of a pay period.
• Accrued vs. deferred: accrued items have the event first and the cash later; deferred items have the cash first and the event later.

FAQs

The Bottom Line

Accruals matter to bookkeepers closing a period and to investors judging whether reported profit reflects real business activity. Accrual accounting shows what a company earned and spent in a period, though it relies on estimates that can be wrong or manipulated. Readers should check the cash flow statement alongside the income statement, since earnings running far ahead of cash can signal slow-paying customers or lower-quality profits.