Financial literacy and accountingModule 2, lesson 4 of 19
Accrual accounting and cash accounting
When revenue and expenses are recorded under accrual accounting, what accrued expenses, prepaid expenses and deferred revenue are, and where judgement comes in.
In this lesson
- Explain when revenue and expenses are recorded under accrual accounting and under cash accounting.
- Identify accrued expenses, prepaid expenses and deferred revenue, and say where each appears.
- Work out profit on both bases for a simple business and explain the difference.
- Explain where accrual accounting needs management's judgement, and why that matters to investors.
Builds on
- Profit compared with cash flowThat lesson shows that profit and cash differ; this one explains the accounting rules that cause the difference.
- Assets, liabilities and equityPrepaid expenses are assets, and accrued expenses and deferred revenue are liabilities.
On this page
In simple terms
There are two ways to decide when a business has earned income and spent money.
- Cash accounting records income when cash arrives and expenses when cash is paid out. It is how most households keep track of money.
- Accrual accounting records income when it is earned, by delivering goods or providing a service, and expenses when they are incurred, by using up goods or services, whatever the timing of the cash.
Listed companies must use accrual accounting. That is why the profit in their income statement is not the same as the cash that came in, a gap explained in profit compared with cash flow.
The two rules behind accruals
Revenue is recorded when it is earned. A sale counts when the goods are delivered or the service is performed, even if the customer pays later. Money owed by customers appears as receivables. And money received before the work is done is not revenue yet.
Expenses are matched to the period they belong to. The cost of goods counts when the goods are sold, salaries count in the month the work was done, and a year's insurance paid in advance is spread over the year it covers.
Three accruals you will see in every set of accounts
| Item | What happened | Where it appears |
|---|---|---|
| Deferred revenue (also called unearned revenue or advances from customers) | Cash received before the service or goods were delivered | A liability: the company owes the customer the service |
| Prepaid expense | Cash paid before the service is used, such as rent in advance | An asset: the company is owed future service |
| Accrued expense | A cost incurred but not yet paid, such as this month's electricity bill | A liability: the company owes the supplier |
Worked example
Worked example: One quarter at a coaching institute
A made-up coaching institute, Gomti Classes, starts in April. In the quarter from April to June:
- It collects ₹12,00,000 in April for a twelve-month course, so it earns ₹1,00,000 a month.
- It pays salaries of ₹60,000 each month.
- In April it pays ₹1,20,000 of rent covering six months, April to September.
- Electricity costs ₹20,000 a month; the bills for April and May are paid, June's is not.
Cash basis:
| Fees received | ₹12,00,000 |
|---|---|
| Salaries paid: 3 × 60,000 | −₹1,80,000 |
| Rent paid for six months | −₹1,20,000 |
| Electricity paid for two months | −₹40,000 |
| Cash surplus for the quarter | ₹8,60,000 |
Accrual basis:
| Revenue earned: 3 months × ₹1,00,000 | ₹3,00,000 |
|---|---|
| Salaries for three months | −₹1,80,000 |
| Rent for three months: 3 × 20,000 | −₹60,000 |
| Electricity for three months, paid or not | −₹60,000 |
| Profit for the quarter | ₹0 |
At the end of June the balance sheet shows deferred revenue of ₹9,00,000 (nine months of teaching still owed to students), a prepaid expense of ₹60,000 (three months of rent already paid) and an accrued expense of ₹20,000 (June's unpaid electricity).
The bank account looks excellent, ₹8.6 lakh up. But the business only broke even, and most of that cash belongs, in effect, to students who have not yet had their classes. If the institute treated the cash as profit and spent it, it would have nothing left to run the course.
Where judgement comes in
Accrual accounting is more informative than cash accounting, but it depends on estimates and decisions made by management:
- When is revenue earned? For a long construction contract or a multi-year software deal, the company has to judge how much of the work is done.
- Will customers pay? Receivables are reduced for amounts expected to go unpaid, which is an estimate.
- What is still owed? Accrued expenses for bonuses, warranties or legal claims are often estimates. The provisions and impairments lesson covers these.
Each estimate can be made cautiously or aggressively. Small changes across many estimates can move reported profit noticeably, which is why investors compare profit with cash over several years.
Why it matters
Accrual accounting is the language of every income statement and balance sheet you will read. Understanding it lets you read items like deferred revenue correctly, for example as a sign of customers paying in advance rather than as a debt in the usual sense, and to notice when profit is running ahead of cash for reasons that deserve a closer look.
Limitations
- Accruals give a truer view of a period only if the estimates behind them are reasonable. They cannot be checked from the headline numbers alone.
- Cash accounting is simpler and harder to manipulate, but it gives a distorted view of any period in which cash and activity are out of step.
- Accounting standards set the rules for recognising revenue, but they leave room for judgement in complex contracts.
Common mistakes
- Treating customer advances as profit. Cash received for work not yet done is a liability until the work is done.
- Assuming a big cash balance means a profitable business, or the reverse.
- Ignoring rising accruals. Receivables or accrued income growing much faster than sales can mean revenue is being recorded too early.
- Reading deferred revenue as bad debt. It is usually a sign that customers pay in advance, which helps cash flow.
Try it yourself
- Find the balance sheet of a company that sells subscriptions or takes advance bookings, such as an airline, an education company or a software firm.
- Look for "deferred revenue", "contract liabilities" or "advances from customers" under liabilities. How large is it compared with a year's revenue?
- Work out the cash basis and accrual basis results for a month of your own household, treating a yearly insurance premium paid this month as you would under each method.
Key takeaways
- Cash accounting records money when it moves. Accrual accounting records revenue when it is earned and expenses when they are incurred, whenever the cash moves.
- Listed companies report on an accrual basis, so their profit is not the same as the cash they collected.
- Cash received before it is earned is a liability called deferred revenue. Cash paid in advance is an asset called a prepaid expense. Costs incurred but not yet paid are accrued expenses.
- Accrual accounting gives a truer picture of a period's performance, but it relies on estimates and judgement.
- When profit and cash keep moving apart, find out which accruals are causing it.
Check your understanding
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Terms used in this lesson
- Accrual accounting
- The accounting method that records revenue when it is earned and costs when they are incurred, rather than when cash changes hands.
- Deferred revenue
- Cash a company has received for goods or services it has not yet delivered. It is a liability until the work is done.
- Prepaid expense
- Cash paid in advance for goods or services that will be used later, such as rent or insurance. It is an asset until used.
- Accrued expense
- A cost that has been incurred but not yet paid, such as this month's electricity bill. It is recorded as an expense and a liability.
- Receivables
- Money owed to a business by customers who have bought on credit and not yet paid.
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This lesson is general education, not investment advice. Examples use made-up or clearly dated figures to explain ideas; they are not recommendations. Read the disclaimer.