Definition of Accrual Basis of Accounting
Under the accrual basis of accounting (or accrual method of accounting), revenues are reported on the income statement when they are earned. When the revenues are earned but cash is not received, the asset accounts receivable will be recorded. (Under the cash basis of accounting, revenues are not reported on the income statement until the cash is received.)
Also under the accrual basis of accounting, expenses are reported on the income statement when they match up with the revenues being reported, or when a cost has no future benefit that can be measured. When an expense occurs and cash has not yet been paid, a liability account will also be recorded. (The expenses that were not paid in the current accounting period will be reported through adjusting entries.)
In other words, under the accrual basis of accounting, the receipt of cash and the payment of cash are not the focus of reporting revenues and expenses. Rather the focus is: 1) what revenues were earned, and 2) what expenses were incurred. Therefore, the accrual basis of accounting provides a more accurate measure of a company's profitability during an accounting period, and a more accurate picture of a company's assets and liabilities at the end of an accounting period.
Example of Reporting Revenues Under the Accrual Basis of Accounting
Let's assume that I begin an accounting business in December and during December I provided $10,000 of accounting services. Since I allow clients to pay in 30 days, none of the $10,000 of fees that I earned in December were received in December. Rather, my clients paid the $10,000 in January. Under the accrual basis of accounting my business will report the $10,000 of revenues I earned on the December income statement and will report accounts receivable of $10,000 on the December 31 balance sheet.
Example of Reporting Expenses Under the Accrual Basis of Accounting
Now let's assume that I paid office rent of $1,500 and incurred $300 of costs for electricity, gas, and sewer/water during December. However, the utilities will not read the meters until January 1, will bill me on January 10 and require that I pay the bill by February 1. Under the accrual basis of accounting I will report the rent expense in December because the rent was used up in December, and I will also report estimated utilities expense of $300 so that the December income statement provides a better measure of December's profitability. Also the December 31 balance sheet will report a liability such as utilities payable of $300 to communicate a more accurate measure of obligations at December 31.
Comparing Accrual Basis to Cash Basis
Using the transactions above, the accrual basis of accounting will result in the December income statement reporting revenues of $10,000 and expenses of $1,800 for a net income of $8,200.
Using the cash basis of accounting the December income statement will report $0 revenues and expenses of $1,500 for a net loss of $8,500 even though I had earned $10,000 in accounting fees. Further, the balance sheet will not report the obligation for the utilities that were used. The January income statement will report the collection of the fees earned in December, and the February income statement will report the expense of using the December utilities. Hence, the cash basis of accounting can be misleading to the readers of the financial statements.
For financial statements prepared in accordance with generally accepted accounting principles, the accrual basis of accounting is required because of the matching principle.