Understanding the Accrual Basis of Accounting

The accrual basis is an accounting method that records financial transactions when they occur, rather than when cash is received or paid. This means businesses recognize revenue when a sale is made or a service is completed—regardless of when payment arrives—and record expenses when an obligation arises, not necessarily when the bill is paid.

For example, if a freelance graphic designer completes a project in December and issues an invoice, the income is recorded in December even if payment is received in January. Conversely, if the designer’s software subscription is billed in December but paid the next month, the expense is recorded in December under the accrual basis.

This approach aligns with the accounting “matching principle,” which pairs revenues with the expenses incurred to generate them, allowing for an accurate representation of a business’s financial health within a specific accounting period.

Accrual Basis vs. Cash Basis: Key Differences

The main alternative to the accrual basis is the cash basis accounting method. While simpler, cash basis accounting recognizes revenue and expenses strictly when cash moves in or out of the business.

Feature Accrual Basis Cash Basis
Revenue Recognition When earned (invoiced or service performed) When cash is received
Expense Recognition When incurred or obligated When cash is paid
Financial Picture Provides a comprehensive view matching income and expenses Reflects cash flow only
IRS Compliance Required for many businesses, especially those with inventory Allowed for some small businesses without inventory

For example, under accrual accounting, a $2,000 invoice sent in December is recorded as revenue in December, whereas, under cash basis, that revenue is recognized only when the payment is received, perhaps in January.

Why the IRS Requires or Prefers the Accrual Basis

According to IRS Publication 538, businesses that maintain inventory or have sales over certain thresholds typically must use the accrual method to accurately track income and deductions (IRS.gov). This is because the accrual method better reflects income earned and expenses incurred during a tax year.

Who usually must use accrual basis?

  • Corporations, especially C-corporations, unless eligible for exceptions
  • Partnerships with a corporate partner
  • Businesses that manufacture, purchase, or sell goods (inventory)
  • Larger businesses seeking detailed financial reporting

Who can use cash basis?

  • Small businesses with average annual gross receipts of $10 million or less over the past three years
  • Service providers without inventory requirements

It’s important to note that switching between methods requires IRS approval and specific filings.

How Accrual Accounting Works in Practice

Example 1: A Bakery

  • Sells 100 cupcakes on credit in December; payment due in January.
  • Electricity bill for December received late December, payable in February.

Under accrual accounting:

  • Revenue from cupcake sales is recorded in December when sold.
  • Electricity expense is recorded in December when incurred.

Under cash basis:

  • Revenue and electricity expense are recorded only when cash changes hands (January and February).

Example 2: Software Company with Subscription Revenue

  • Receives $12,000 upfront in July for a 12-month service contract.

Accrual accounting spreads the $12,000 evenly over 12 months ($1,000 recognized monthly), aligning revenue with service delivery.

Cash basis would record the whole $12,000 in July, potentially distorting monthly income.

Best Practices for Using the Accrual Basis

  1. Use accounting software that supports accrual tracking for accounts receivable and payable.
  2. Maintain detailed records of invoices and bills to accurately record revenues and expenses when they occur.
  3. Regularly reconcile accounts to identify discrepancies early.
  4. Consult with a CPA or accountant to ensure compliance and optimal tax strategy.
  5. Analyze financial statements prepared on an accrual basis to inform management decisions.

Common Challenges and Misconceptions

  • Confusing accrual accounting with cash flow management; being profitable on paper doesn’t mean having cash available.
  • Missing to accrue certain expenses not yet invoiced, which can misstate profitability.
  • Premature revenue recognition before delivery or performance can lead to errors and penalties.
  • Assuming cash basis is universally acceptable, which is incorrect for many business types.

Frequently Asked Questions (FAQs)

Q1: Must I use the accrual basis if I have inventory?
Yes, the IRS generally requires businesses with inventory to use accrual accounting for sales and purchases to accurately reflect income.

Q2: Can I switch from cash to accrual basis?
You can, but it requires IRS approval through a change in accounting method process using Form 3115.

Q3: How does the accrual basis affect my taxes?
You report income when earned, not when received, which can lead to paying taxes before actually receiving cash.

Q4: Which method is better, cash or accrual?
It depends on your business size, type, and complexity. Accrual is more accurate and often required for larger or inventory-based businesses.

Sources and Further Reading

For more on accounting basics and tax planning, see our related articles on Accounting Methods and Tax Planning.