How Do Accruals Work?

Accruals are an accounting method for recording revenues and expenses. Companies can report revenues and expenses on a cash basis or an accrual basis. While cash is eventually involved in revenue and expense transactions, using accruals, companies report revenues when earned and expenses when incurred without the exchange of cash at the time of a sale or a cost purchase. Companies may accrue revenues and expenses from prepayments and deferred payments.

The accrual method of accounting requires that companies report revenues in the period in which a revenue is earned and realizable, regardless of whether cash is paid by customers on a related sale. A revenue is earned when companies have completed a sale transaction of delivering goods or performing services for customers. A revenue is realizable when companies expect that customers will make their cash payments later on a sale that has been provided to them.

Companies accrue and report expenses in the period in which an expense is incurred to match with the revenue that the incurrence of the expense helps generate, based on the expense matching principle of the accrual method of accounting. Thus, expense accruals don’t require companies make cash payments to pay for an expense at the time of a transaction. Without accruing expenses, companies mismatch expenses with revenues, overstating revenues in some periods and understating revenues in other periods.

Using accruals, companies may record revenues as earned before cash from a sale is received or after customers have prepaid for a sale transaction. When a revenue is recognized in the period in which it is earned, companies record the revenue by crediting the revenue account and debiting the accounts receivable, an account used to track the amount of cash owed by customers on completed sales. However, the accrual method of accounting doesn’t permit any revenue recording on cash prepaid for future sales transactions. Companies can accrue revenues as future sales transactions are completed over time.

Using accruals, companies record expenses when incurred with or without any cash payments for the expenses. To record an expense in the period in which it is incurred, companies debit the expense account and credit the accounts payable, an account used to track the amount of cash owed by the company to suppliers. On the other hand, companies may prepay cash on future expenses that have not been incurred, and as a result cannot record any expense at the time of the cash payments but rather accrue expenses as companies use the prepayments to cover related future expenses.