Accrual Accounting

Accrual accounting recognizes economic events when they occur rather than when cash changes hands. Revenue is recorded when it is earned and expenses when they are incurred, so the reported result for a period reflects what the business did in that period instead of what its bank account happened to do. GAAP requires it, and any entity of meaningful size ends up on it whether or not it wants to be.

The alternative is the cash basis, which records revenue on receipt and expense on payment. Cash basis statements are simpler, they map directly to the bank, and they are systematically misleading whenever the timing of payment differs from the timing of activity. A December project invoiced in December and paid in February appears in the wrong year, and the year with the work in it shows no revenue for it.

Four mechanisms implement accrual accounting at period end. Accrued expenses record costs incurred but not yet invoiced. Accrued revenue records amounts earned but not yet billed. Prepaid expenses defer costs paid in advance into the periods that benefit. Deferred revenue defers amounts collected in advance until the performance obligation is satisfied. All four are recorded as adjusting entries during the close, and many are reversed at the start of the following period so the eventual invoice can be recorded normally.

The tax rules are a separate system that happens to share the vocabulary. Section 448 restricts who may use the cash method, generally excluding C corporations, partnerships with a C corporation partner, and tax shelters, while permitting entities that meet the gross receipts test to use it regardless. For an accrual method taxpayer, an expense is deductible when the all-events test is met and economic performance has occurred under Section 461, which is a higher bar than book accrual and routinely defers deductions the financial statements have already taken. On the income side, Section 451(b) requires an accrual method taxpayer with an applicable financial statement to recognize income no later than when it is taken into revenue in that statement, and Section 451(c) allows a limited one-year deferral for certain advance payments.

The practical consequence is that the book accrual and the tax accrual almost never agree, and the differences are not errors. They are temporary book-tax differences, and they have to be identified, quantified, and tracked, because they drive the deferred tax balances and the return-to-provision reconciliation. Reserves and allowances, accrued bonuses and vacation, prepaid items, and warranty and rebate accruals are the recurring offenders.

Changing between the cash and accrual methods is an accounting method change requiring Form 3115 and a Section 481(a) adjustment. Crossing the gross receipts threshold in either direction is a scheduled event, not a surprise, and it should be planned for before the year it applies.

Related terms: Accrued Expenses, Adjusting Journal Entry, Deferred Revenue, Book-Tax Differences

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Accruals are the part of the close most often carried forward on faith. Adopt's agents rebuild them from the underlying activity each period and flag the ones that no longer match what the business actually did. Sign up free.