Legal Definitions - accrual accounting method

The accrual accounting method is a financial reporting technique where income and expenses are recorded when they are earned or incurred, rather than when cash actually changes hands. This means that revenue is recognized as soon as a service is provided or a product is delivered, even if the customer hasn't paid yet. Similarly, expenses are recorded when a company receives a bill for goods or services, even if the payment isn't made until later. This method aims to provide a more accurate representation of a company's financial performance and obligations during a specific period.

Here are some examples to illustrate the accrual accounting method:

• Example 1: Consulting Services

  A marketing consulting firm completes a major project for a client on December 20th, sending an invoice for $10,000. The client's payment terms allow 30 days, so the firm expects to receive the payment in mid-January of the following year.

  Under the accrual accounting method, the consulting firm would record the $10,000 as revenue in December, when the service was completed and the income was earned, even though the actual cash receipt will occur in January. This accurately reflects the firm's performance for the December accounting period.

• Example 2: Office Utility Bills

  A small business uses electricity throughout March. The utility company reads the meter at the end of March, sends the bill in early April, and the business pays it in mid-April.

  Using accrual accounting, the business would record the electricity cost as an expense in March, the month the electricity was consumed (incurred), even though the bill was received and paid in April. This ensures that the expenses are matched to the period in which they were used to operate the business.

• Example 3: Annual Software Subscription

  A software-as-a-service (SaaS) company sells an annual subscription to a customer for $1,200 on January 1st. The customer pays the full $1,200 upfront for a year of service.

  With accrual accounting, the SaaS company would not record the entire $1,200 as revenue in January. Instead, it would recognize $100 as revenue each month ($1,200 / 12 months) over the course of the year. This is because the service (access to the software) is provided continuously throughout the year, meaning the revenue is earned incrementally, not all at once when the cash is received.