Accrual Accounting: How It Works, Types, and Why It Matters

To evaluate any business or organization's financial performance and make wise decisions, you need an accurate record of income, expenses, and savings. But here is the question — when exactly should you record a transaction? When the work is done? Or when the cash hits your bank account?

Accrual accounting is the method that answers this question. It records revenue when it is earned and expenses when they are incurred — regardless of when the actual cash changes hands. So if you provide consulting services in July but do not get paid until August, accrual accounting says you earned that revenue in July. The payment timing does not matter.

In simple terms, accrual accounting matches income with expenses within the same period, giving you the most accurate picture of your company's financial condition. It is the method required by both GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards), which is why most publicly traded companies and serious businesses around the world use it.

Revenue Recognition Principle

This is the foundation of accrual accounting. The revenue recognition principle says that revenue should be recognized — meaning recorded in your books — when it is earned, not when payment is received.

Here is a real-world example. A consulting firm provides services to a client in July but receives payment in August. Under accrual accounting, the revenue is recorded in July — because that is when the work was done and the value was delivered. The August payment is just the cash catching up.

Another example: a software company sells annual subscriptions. Even if a customer pays the full year upfront in January, the company does not record all of it as January revenue. Instead, it recognizes 1/12th of the revenue each month, because the service is being delivered over 12 months. This prevents revenue figures from being artificially inflated in one period.

Expense Matching Principle

The expense matching principle says that expenses should be recorded in the same period as the revenue they helped generate. This creates a direct link between what you spent and what you earned.

For example, suppose a company buys inventory in July to sell products in August. Under accrual accounting, the cost of that inventory is not recorded as an expense in July when it was purchased — it is recorded in August when the products are actually sold. This way, the August income statement shows both the revenue from the sale and the cost of the goods sold, giving you an accurate view of that month's profitability.

Without this principle, your financial statements would be misleading. You might show huge expenses in one month (when you bought inventory) and huge revenue in the next (when you sold it), making it impossible to understand the true profitability of each period.

Consistency Principle

The consistency principle requires that once a company chooses an accounting method, it should stick with it across all reporting periods. This ensures that financial statements are comparable over time.

For example, if a company uses the straight-line method to depreciate its assets in Year 1, it should continue using the same method in Year 2, Year 3, and beyond. Switching methods every year would make it nearly impossible for investors or analysts to compare performance across periods. Consistency builds trust and reliability in financial reporting.

Revenue Accrual

Revenue accrual means recognizing revenue when it is earned, not when payment is received. This is the most common type of accrual.

Example: A software development company completes a project for a client in March. The client agrees to pay in April. Under revenue accrual, the company records the full revenue in March — because the work was completed and the obligation to the client was fulfilled. The April payment simply settles the accounts receivable.

Expense Accrual

Expense accrual means recording expenses when they are incurred, even if the actual payment has not been made yet.

Example: Your company uses electricity throughout December. The bill arrives in January. Under expense accrual, you record the electricity expense in December — because that is when you actually used the electricity. The January payment just clears the liability. This is exactly how accrued liabilities work.

Prepaid Expense Accrual

Prepaid expenses are costs you pay in advance for services or benefits you will receive in the future. Under accrual accounting, these are not recorded as expenses immediately — they are recognized gradually over the period they benefit.

Example: A company pays 1,20,000 taka for a 12-month insurance policy in January. Instead of recording the entire amount as a January expense, the company records 10,000 taka per month for 12 months. This way, each month's financial statement reflects only the insurance cost relevant to that month.

Unearned Revenue Accrual

Unearned revenue is money you have received for services or products you have not yet delivered. Under accrual accounting, this money is recorded as a liability — not revenue — until you actually deliver what was promised.

Example: A gym collects 12,000 taka from a member for a one-year membership in January. The gym does not record all 12,000 taka as January revenue. Instead, it records 1,000 taka each month as the member uses the facility. The remaining balance sits as a liability on the balance sheet until it is earned.

The accrual accounting process follows a clear, step-by-step flow. Let us walk through it.

Step 1: Identify the transaction. Whenever a business event occurs that has financial implications — a sale, a purchase, a service rendered — it needs to be identified and documented.

Step 2: Record it in the journal. Using double-entry bookkeeping, the transaction is recorded with a debit and a credit entry. For example, when you make a sale on credit, you debit accounts receivable and credit sales revenue.

Step 3: Post to the ledger. Journal entries are transferred to the general ledger, where they are organized by account. This gives you a consolidated view of each account's balance.

Step 4: Make adjusting entries. At the end of the accounting period, adjusting entries are made to ensure that all revenues earned and expenses incurred are properly recorded — even if no cash has moved. This is the heart of accrual accounting.

Step 5: Prepare financial statements. Using the adjusted trial balance, you prepare your income statement, balance sheet, and cash flow statement. These statements reflect the true financial position of the business.

Accurate Financial Picture

By matching revenue with the expenses that generated it, accrual accounting provides a realistic view of your company's financial health. You see the full picture — not just the cash that has moved, but the economic reality of what was earned and owed.

Compliance with Accounting Standards

Most financial reporting standards — including GAAP in the United States and IFRS used internationally — require accrual accounting. If your company is publicly traded, seeking investment, or operating in a regulated industry, accrual accounting is not optional. It is mandatory.

Better Decision Making

When you base decisions on accrual data instead of just cash movements, you get a much clearer understanding of your business. For instance, if your revenue is growing but your cash balance is shrinking, accrual accounting helps you see that the issue might be slow-paying customers — not weak sales. That insight changes your response entirely.

Meaningful Comparisons

Accrual accounting allows you to compare financial performance across different periods in a meaningful way. Since revenue and expenses are matched to the period they belong to, you can track trends accurately. Is this quarter better than last quarter? Is the company growing or shrinking? Accrual accounting answers these questions reliably.

Handles Complex Transactions

Real-world business is messy. You have installment sales, long-term contracts, deferred revenue, and multi-period expenses. Cash accounting struggles with these. Accrual accounting was designed to handle this complexity — recording each element in the correct period so your financial statements always tell the truth.

Accrual accounting is not without its downsides. Here are the main challenges businesses face:

Complexity — Accrual accounting is significantly more complex than cash accounting. It requires adjusting entries, careful tracking of receivables and payables, and a solid understanding of accounting principles. Small businesses or startups without accounting expertise may find it overwhelming.

Cash flow disconnect — Your income statement might show a healthy profit, but your bank account could be nearly empty. Because accrual accounting records revenue before cash is received, it can sometimes create a false sense of security about your liquidity. You still need to monitor cash flow separately.

Higher costs — Implementing accrual accounting typically requires accounting software, trained staff, or professional accountants. For very small businesses, these costs can be significant relative to their revenue.

Estimation risk — Accrual accounting sometimes involves estimates — like estimating bad debts, warranty liabilities, or the useful life of assets. If these estimates are wrong, your financial statements may not be as accurate as intended.

Accrual accounting is the gold standard of financial reporting. By recording transactions when they are earned or incurred — rather than when cash moves — it provides the most accurate and complete picture of a company's financial health. Yes, it is more complex than cash accounting, and yes, it requires more effort and expertise. But the benefits far outweigh the costs.

Whether you are a growing startup, a mid-sized company, or a multinational corporation, accrual accounting gives you the tools to make informed decisions, comply with global standards, and present your finances with clarity and integrity. If you are serious about understanding where your business truly stands financially, accrual accounting is the way to go.