The need for accrual accounting arose because business has changed in the modern world. Go back several hundred years and we find that business transactions were conducted by barter or cash. In other words, each transaction was ‘settled’ immediately. That is relatively uncommon now. Now a transaction occurs and one party sends an invoice to the other party, who pays later. We can say that these debts have accrued, whether we’ve accrued accounts receivable to a customer or accounts payable to a supplier. Companies accrue wages to employees between paydays.
Using the accrual method, a company records every activity that happens in the business as it happens, regardless if cash changed hands. For example, revenue is recognized when a product or service is ‘delivered’ to a customer. At this moment, the profit is also recognized because it has been ‘earned.’ When payment for the invoice is received does not affect when the revenue and earnings are recognized. Contracts with customers may require advance payments, payments at certain milestone events, monthly progress payments, payment on completion, or payment 30 to 60 days after completion. These are all agreed upon payment methods between a company and its customers that have no impact on recognizing revenue and profit.
The advantage of accrual accounting is that it provides a true and accurate picture of a company’s financial position and profitability. Bankers, shareholders and company managers all want a true picture of the company’s financial position, so they will request accrual records.
What businesses must use accrual accounting?
Most countries require accrual based accounting with the United States being the one exception that allows some companies to use cash basis accounting. In the US, all publicly traded companies must use accrual accounting. Any company that sells a physical product and has ‘inventory’ must use accrual accounting. Privately held service companies such as doctors, attorneys, consultants, training companies, real estate agents, etc. can use the cash method of accounting up to a limit. Currently in the US, service companies whose revenue exceeds $10,000,000 for three consecutive years must switch to the accrual method. Cash basis accounting is allowed for small privately held service companies because it allow them to defer revenue and profits and, therefore defer the payment of taxes. This helps small companies have better cash flow.