Accrual accounting
Recording revenue when it is earned and expenses when they are incurred, whenever the cash actually moves.
In short
- A sale made in March is March revenue, even if the customer pays in May.
- It gives a truer picture of profit than counting cash in and out.
- In Canada, most businesses must use it for income tax, and financial reporting standards require it.
Accrual accounting records transactions in the period they belong to, not the period the money changes hands. Revenue is recognized when it is earned, usually when goods are delivered or services performed. Expenses are recognized when they are incurred, usually when the goods or services are received.
Why it exists
Cash timing can make a business look very different from month to month. A consulting firm that does a large project in March but is paid in May would show a loss in March and a windfall in May under cash accounting, though nothing about the business changed. Accrual accounting puts the revenue in March, next to the salaries and costs that produced it, so each period's profit reflects what actually happened.
The tools it needs
- Receivables and payables: amounts earned or owed but not yet paid.
- Accrued expenses: costs incurred but not yet invoiced, recorded at period end.
- Prepaid expenses: costs paid in advance and spread over the periods they cover.
- Deferred revenue: customer payments received before the work is done.
- Depreciation: spreading the cost of long-lived assets over their useful life.
Accrual accounting is required under IFRS, ASPE and US GAAP. In Canada, the CRA generally requires it for business income, with limited exceptions such as farming and fishing.
Worked example
The same quarter, two ways
A firm completes a $90,000 project in March and pays $60,000 of costs that month. The client pays in May. On a cash basis, March shows a $60,000 loss and May a $90,000 gain. On an accrual basis, March shows $90,000 of revenue and $60,000 of expenses, a $30,000 profit, and May shows only the receivable being collected.