How do you calculate accrual basis accounting?

Accrual basis accounting is one of the most widely used accounting methods in business. It records income when it is earned and expenses when they are incurred, even if money hasn’t changed hands yet. This method helps companies better understand their actual financial performance.
This article will explain what accrual basis accounting is, how to calculate accruals, and give examples. We will also cover why it’s important and how to apply it easily in any business.

What Is Accrual Basis Accounting?

Basic Meaning

• Accrual basis accounting is a method that records revenues and expenses when they occur.
  
• It doesn’t wait for cash to come in or go out.
  
• This gives a more accurate view of a company’s financial status.
  

Example

• If a company delivers goods in June but receives payment in July, the income is recorded in June.
• The same applies to expenses; if you receive a bill in December but pay it in January, you still record it in December.
  

Why It Matters

• Helps match income with related expenses.
• Gives a complete picture of profits for a specific period.
• Helps in creating proper financial reports.

Types of Accruals in Accounting

Understanding accruals calculation is easier when you know the types of accruals.

1. Accrued Revenues

• Money earned but not yet received.
• Example: You perform a service in March, but payment comes in April.
• You record it as income in March.
  

2. Accrued Expenses

• Costs that are incurred but not yet paid.
• Example: You receive an electric bill in December, and pay in January.
• You record it as an expense in December.
  

3. Deferred Revenues

• Cash received before work is done.
• Example: A customer pays in advance in June for a service to be done in July.
• You record revenue in July.
  

4. Deferred Expenses

• Payments are made in advance.
• Example: You pay rent for the year in January.
• Only the portion used each month is recorded as an expense.
  

Accruals Calculation: Step-by-Step Process

Let’s look at how to calculate accruals using simple steps.

Step 1: Identify the Transaction

• Ask: Has the income been earned?
• Ask: Has the expense been incurred?
• If yes, record it, even if no cash has moved.
  

Step 2: Determine the Amount

• Use invoices, bills, or internal records to calculate the correct amount.
• Make sure it’s for the right accounting period.
  

Step 3: Make the Journal Entry

For Accrued Revenue:

• Debit: Accounts Receivable
• Credit: Revenue
  

For Accrued Expense:

• Debit: Expense
• Credit: Accounts Payable
  

Step 4: Adjust at Period End

• At the end of each month or year, update records.
• Use adjusting journal entries to reflect any unpaid or unearned items.
  

Example: How to Calculate Accruals

Let’s go through two quick examples:

Example 1: Accrued Income

• A marketing company completes a job worth $5,000 in December.
• The client pays in January.
• The company records $5,000 in income in December.
  

Journal Entry:

• Debit Accounts Receivable $5,000
• Credit Service Revenue $5,000
  

Example 2: Accrued Expense

• A business gets a bill for $2,000 in December. It pays in January.
• The business records the $2,000 expense in December.
  

Journal Entry:

• Debit Utilities Expense $2,000
• Credit Accounts Payable $2,000
  

Benefits of Accrual Basis Accounting

1. Better Matching of Income and Expenses

• Income and expenses are recorded in the same period.
• This gives a clear picture of profits and losses.
  

2. Accurate Financial Reports

• Reports reflect real business activities.
• Helps managers and investors make decisions.
  

3. Required by GAAP

• For large businesses, accrual basis accounting is mandatory.
• It is part of the Generally Accepted Accounting Principles.
  

4. Useful for Long-Term Planning

• You can forecast future performance.
• Helps in budgeting and financial analysis.
  

Drawbacks of Accrual Basis Accounting

While accrual basis accounting gives a full picture of a business’s finances, it also has some downsides that can be hard for small firms or those without strong accounting skills. Here are some key drawbacks to consider:

1. More Complete

Accrual accounting is harder to understand than the cash basis. It needs more training and solid knowledge of accounting. If entries are not made right, your books can be wrong. This can affect your reports and lead to bad choices.

2. Doesn’t Show Cash Flow

You might show a profit on paper but still not have cash. This can be risky if you need to pay bills or workers. Accrual does not show how much cash is in hand. You will still need a cash flow report to stay in control.

3. Harder for Small Businesses

Most small firms don’t have trained staff or tools. Keeping records this way takes more time and skill. It may cost more if you need to hire help. For this reason, many small firms stick to cash basis.

4. Frequent Adjusting Entries Needed

Each period, you must add or change records. If you forget or miss an entry, your books can be wrong. You have to track what is owed and what is due. This adds more work and calls for more care.

5. May Require Professional Help

Doing accruals right takes time and know-how. Many small business owners can’t do it on their own. They must hire a bookkeeper or a CPA. This adds to costs and may not fit all budgets.

Accrual Accounting vs. Cash Accounting

How to Switch to Accrual Basis Accounting

Step 1: Review All Past Transactions

• Check income and expenses not yet received or paid.

Step 2: Adjust Your Books

• Make entries for all accrued income and expenses.

Step 3: Update Accounting Software

• Use tools like QuickBooks, Xero, or Zoho to handle accruals.

Step 4: Consult an Accountant

• A professional can guide you through a smooth transition.

Tips for Effective Accruals Calculation

• Always check invoice dates and billing periods.
• Maintain clear records for receivables and payables.
• Review and adjust your accounts monthly.
• Use accounting software to automate accrual entries.
• Create a checklist to ensure nothing is missed.
  

Real-Life Use of Accrual Basis Accounting

Large Businesses

• Required to use accrual accounting for tax purposes if revenue exceeds $25 million annually.

Freelancers and Contractors

• Should use accruals if they deal with delayed payments.

Service Providers

• Helpful for businesses that invoice monthly but work daily.
  

Accruals in Financial Statements

In the Income Statement

• Revenue is recorded when earned.
• Expenses are recorded when incurred.

In the Balance Sheet

• Accounts Receivable shows income due.
• Accounts Payable shows expenses not yet paid.
  

Knowing how to calculate accruals helps businesses understand their real profits and losses. It provides more meaningful data for decision-making. Though it may seem complicated at first, it becomes easier with practice and proper tools.

Using accrual basis accounting gives you better control over your finances. By recording transactions when they happen, not just when cash changes hands, you get a full view of your business.

If you’re looking to improve your accounting practices, switching to accrual basis accounting and learning how to calculate accruals is a smart move. It offers deeper insights, better planning, and more reliable financial reports. Always keep your records up to date and consult a professional if needed. Meru Accounting, a trusted provider of outsourced accounting services, specializes in helping businesses transition smoothly to accrual basis accounting. With expert support and tailored solutions, we ensure accurate financial reporting and improved decision-making.

FAQs

Q1: What is accrual basis accounting?
A1: It records income and expenses when they occur, not when money is exchanged.

Q2: What is the accruals calculation?
A2: It’s the process of adding unpaid income or expenses to the books during the right period.

Q3: How to calculate accruals easily?
A3: Identify, measure, and record income or expenses before cash changes hands.

Q4: What are examples of accruals?
A4: Unpaid bills, unpaid salaries, or services rendered but not paid.

Q5: Do I need special software for accrual accounting?
A5: Software like QuickBooks or Xero makes it easier, but you can do it manually too.

Q6: Is accrual accounting better than cash accounting?
A6: It depends on your business type. Accrual is better for tracking long-term finances.

Q7: Can a small business use accrual accounting?
A7: Yes, and it can help improve their financial planning and reporting.