Accrual basis accounting is typically best because it offers the most accurate information about your business’s performance. But its complexity may outweigh its benefits for simple, very small businesses. Ultimately, the right accounting method for you will depend on your business’s needs and whether you plan to track accounts receivable and payable.

Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. After submitting your application, you should receive an email confirmation from HBS Online. If you do not receive this email, please check your junk email folders and double-check your account to make sure the application accrual basis accounting was successfully submitted. Harvard Business School Online’s Business Insights Blog provides the career insights you need to achieve your goals and gain confidence in your business skills. As a result, an investor might conclude the company is making a profit when, in reality, the company might be facing financial difficulties.

What is Modified Accrual Accounting?

Accrual basis accounting records income and expenses when they’re incurred, regardless of whether money has been exchanged yet. The accrual basis of accounting
recognizes revenues when earned (a product is sold or a service has
been performed), regardless of when cash is received. Expenses are
recognized as incurred, whether or not cash has been paid out. For
instance, assume a company performs services for a customer on
account. Although the company has received no cash, the revenue is
recorded at the time the company performs the service. Later, when
the company receives the cash, no revenue is recorded because the
company has already recorded the revenue.

• Revenue is not difficult to define or measure;
  it is the inflow of assets from the sale of goods and services to
  customers, measured by the cash expected to be received from
  customers.
• Basically, accrued revenue refers to any goods or services that the entity sold or performed for its customers and has not issued an invoice or bill to its customers yet.
• To have the proper revenue figure for the year on the utility’s financial statements, the company needs to complete an adjusting journal entry to report the revenue that was earned in December.
• For example, if a company incurs expenses in December for a service that will be received in January, the expenses would be recorded in December, when they were incurred.
• That timing discrepancy could make it difficult for you to determine whether that job was profitable.

If you work with an accountant, you can easily share your spreadsheets to provide an accurate look at your finances and tax obligations. Accrual-focused accounting tracks revenue as it is earned and expenses the moment they are incurred. This system makes use of accounts payable and accounts receivable to formulate an accurate, real-time picture of the financial status of your business. In contrast, with the accrual method, payments are recorded when earned, giving the business a better sense of the company’s actual sales and profits. Additionally, cash-basis accounting can make obtaining financing more difficult due to its high probability of inaccuracies.

Why Is Accrual Accounting Important?

The electricity company needs to wait until the end of the month to receive its revenues, despite the in-month expenses it has incurred. Meanwhile, the electricity company must acknowledge that it expects future income. Accrual accounting gives the company a means of tracking its financial position more accurately.

Similarly, expenses are recorded when they are incurred, regardless of when they are paid. For example, if a company incurs expenses in December for a service that will be received in January, the expenses would be recorded in December, when they were incurred. Professionals such as physicians
and lawyers and some relatively small businesses may account for
their revenues and expenses on a cash basis. The cash basis
of accounting recognizes revenues when cash is received
and recognizes expenses when cash is paid out. For example, a
company could perform work in one year and not receive payment
until the following year.