Legal Definitions - accrual basis

The accrual basis is an accounting method where financial transactions are recorded when they occur, regardless of when cash actually changes hands. This means that revenues are recognized when they are earned (for example, when goods are delivered or services are performed), even if payment has not yet been received. Similarly, expenses are recognized when they are incurred (for example, when a bill is received for services rendered), even if the payment has not yet been made.

The primary goal of the accrual basis is to provide a more accurate picture of an entity's financial performance over a specific period by matching income and related expenses in the same reporting period, rather than simply tracking cash inflows and outflows.

• Example 1: Revenue Recognition

  Imagine a graphic design studio that completes a large website project for a client in December. The client is happy with the work, but due to their internal payment cycle, they don't send the invoice until January, and the payment isn't received until February.

  Under the accrual basis, the graphic design studio would record the revenue from this project in December, because that is when the service was fully performed and the income was earned, even though the cash payment arrived later. This accurately reflects the studio's earnings for the month of December.

• Example 2: Expense Recognition

  Consider a small manufacturing company that uses a significant amount of raw materials throughout the month of March. The supplier ships the materials in March, and the manufacturing company receives the bill for these materials at the end of March. However, the company's payment terms allow them to pay the bill in April.

  Using the accrual basis, the cost of these raw materials would be recorded as an expense in March, because that is when the materials were used in production and the liability to pay for them was incurred. This matches the expense to the period in which the materials contributed to the company's output, regardless of when the cash payment was made.

• Example 3: Services Provided Over Time

  A fitness center sells a one-year membership to a new client for $600 in January. The client pays the full amount upfront.

  Under the accrual basis, the fitness center would not record the entire $600 as revenue in January. Instead, it would recognize $50 ($600 divided by 12 months) as revenue each month for the next 12 months. This is because the service (access to the gym) is provided evenly over the year. This approach accurately reflects the revenue earned in each specific month as the service is delivered, providing a clearer view of the center's monthly performance.