Facts

• Since the purpose of an accounting accrual is to better match income with expenses, the accrual basis of accounting records income when it is earned and expenses when they were incurred, regardless of when cash is received or paid. In contrast, the cash basis of accounting makes no use of accruals, simply recording the income and expenses as they are received and paid. The use of accrual accounting is particularly suited to larger companies, those with inventory or accounts receivable, and those needing audited financial statements. Many businesses start out with the simple cash basis method, graduating to the use of accrual accounting later one.
  
  

Types

• Accrual accounting entries actually fall into two categories: accruals and deferrals. An accrual is used when revenue or expenses are recognized before cash is received or paid. An accounting deferral, on the other hand, refers to recognition of revenues or expenses at some time after cash has been transferred. In other words, accruals refer to the recognition of accounting events before cash flows, while an accounting deferral relates to the recognition of events after cash flows.
  
  For example, you might accrue income earned but not yet received. You might also accrue costs that match up with current income but are not yet paid. When a customer pays in advance (that is, the cash comes before you earn the income), you would defer the income into the accounting period when it was actually earned. Expenses paid in advance also result in an accounting deferral. The key then to determining whether a transaction is an accrual or a deferral is asking if the cash moved before or after the accounting event.
  
  

Considerations

• Accruals are generally based on estimates and assumptions. Those estimates, if found to be inaccurate, require correction in later financial periods. Such corrections (or reversals as they are called) affect earnings in subsequent periods. For example, if costs accrued on a project were later found to be greatly overestimated, an accounting entry in a later period would correct the overstatement. Unfortunately, both periods would then be misstated. The significance of that misstatement would depend on how large the overestimate was.
  
  

Benefits

• A number of benefits can obtain from using accrual basis accounting. Many banks require accrual-based financial statements. As a result, businesses that use the accrual method of accounting have a head start in the borrowing process. Audited financial statements also require the use of accrual accounting.
  
  The use of accruals also leads to more comprehensive recordkeeping and better tracking of both liabilities and cash on hand. Tax benefits to be derived from accrual accounting include the fact that expenses can be counted towards a tax deductions even if the purchase isn't technically paid for until the following year, as long as the transaction occurred in the tax year in question.
  
  

Expert Insight

• A degree of judgment is required to estimate proper accrual amounts. Some would also say that the ability to manipulate accruals leaves the financial statements open to manipulation. As a general rule, however, such estimation errors (or deliberate manipulations) merely shift reported earnings from one period to another, as accruals typically reverse over time.