What is accrual accounting? How it works and examples

Published Friday 20 March 2026

Table of contents

• Accrual accounting definition
• How accrual accounting works
• Accrual accounting vs cash accounting
• Why accrual accounting matters for small businesses
• Advantages of accrual accounting
• Disadvantages of accrual accounting
• Types of accruals
• When to use accrual accounting
• How Xero simplifies accrual accounting
• FAQs on accrual accounting

Key takeaways

• Record revenue when you earn it and expenses when you incur them, not when cash changes hands, to get a more accurate picture of your business's true financial performance.
• Consider switching to accrual accounting if you're seeking investors or loans, selling products with inventory, or planning to grow your business beyond simple freelance work.
• Understand that accrued revenue (money earned but not yet received) shows as an asset on your balance sheet, while accrued expenses (costs incurred but not yet paid) appear as liabilities.
• Use accounting software to automate the complexity of tracking receivables and payables, making accrual accounting manageable without hiring additional help.

Accrual accounting definition

Accrual accounting is a method where you record revenue when it's earned and expenses when they're incurred, not when cash changes hands. This gives you a more accurate view of your business's financial health over time.

Accrual accounting requires more effort than cash accounting, but it offers important advantages:

• Accuracy: Provides a more complete long-term view of your finances
• Credibility: Many investors and lenders prefer working with businesses that use accrual accounting
• Compliance: Tax authorities may require certain business types and sizes to use this method

Accrual accounting keeps tabs on bills and sales invoices that are yet to be paid.

How accrual accounting works

The matching principle is the foundation of accrual accounting, requiring you to record revenue in the same period as its related expenses. For example, accounting standards provide specific guidance on recognizing the incremental costs of obtaining a contract, which helps give a clearer picture of profitability.

Here's how timing works with accrual accounting:

• Revenue recognition: Record income when you complete the work or deliver the product; official accounting standards state that revenue is recognized when an entity satisfies a performance obligation
• Expense recognition: Record costs when you receive goods or services, not when you pay the bill

For example, you finish a consulting project in December but don't receive payment until January. With accrual accounting, you record the revenue in December because that's when you earned it. This shows your true December performance, even though the cash arrives later.

Accrual accounting vs cash accounting

The main difference between the two methods is timing. Cash accounting records transactions when money moves. Accrual accounting records transactions when they're earned or incurred.

Here's how they compare:

When revenue is recorded:

• Cash basis: When you receive payment
• Accrual basis: When you earn the income (complete the work or deliver the product)

When expenses are recorded:

• Cash basis: When you pay the bill
• Accrual basis: When you incur the cost (receive goods or services)

Complexity level:

• Cash basis: Simpler to manage and understand
• Accrual basis: Requires more tracking but provides better financial insight

Best for:

• Cash basis: Freelancers, solopreneurs, and service businesses with simple finances
• Accrual basis: Businesses with inventory, those seeking investors, or companies required by tax law

Cash flow visibility:

• Cash basis: Shows exactly how much cash you have right now
• Accrual basis: Shows money owed to you and money you owe, but requires separate cash flow tracking

Why accrual accounting matters for small businesses

As your business grows, understanding your full financial picture becomes more important. Accrual accounting gives you a more accurate picture of your business performance by showing revenue and expenses in the periods they actually relate to.

Here's why small businesses use accrual accounting:

• Better decision-making: See true profitability by matching revenue with the costs that generated it
• Investor and lender requirements: Many banks and investors expect accrual-based financial statements before providing funding
• Inventory tracking: If you sell products, accrual accounting properly matches inventory costs with sales
• Growth preparation: Switching methods later can be complicated, so starting with accrual sets you up for scale
• Tax compliance: C-corporations and businesses with over $25 million in annual revenue must use accrual accounting

Advantages of accrual accounting

Accrual accounting provides a more complete view of your financial health than cash accounting. Here are the key benefits for small businesses:

• Shows accurate profitability: Matches revenue with related expenses so you see true profit margins for each period
• Improves cash flow forecasting: Tracks money owed to you (accounts receivable) and money you owe (accounts payable) in one place
• Supports better planning: Reveals financial trends and patterns that help you make informed decisions
• Builds credibility: Demonstrates financial sophistication to investors, lenders, and potential buyers
• Simplifies tax preparation: Keeps records organized throughout the year, making tax time less stressful

Disadvantages of accrual accounting

Accrual accounting requires more effort than cash accounting. Before switching methods, consider these challenges:

• Adds complexity: Requires tracking receivables and payables. This complexity is acknowledged in accounting standards, which offer a practical expedient to simplify cases where payment is expected within a year of service
• Takes more time: Demands consistent bookkeeping to record transactions when they occur, not just when cash moves
• May require help: Many small business owners hire a bookkeeper or accountant to manage accrual accounting properly
• Obscures cash position: Shows money you've earned but haven't received, which can make your actual cash balance less obvious
• Needs regular attention: Requires ongoing maintenance to keep records accurate and up to date

Accounting software can reduce much of this complexity by automating calculations and tracking.

Types of accruals

There are two main types of accruals in accounting: accrued revenue and accrued expenses. Understanding both helps you record transactions at the right time.

Accrued revenue

Accrued revenue is income you've earned but haven't yet received payment for. This happens when you complete work before the customer pays.

For example, you run a software subscription service and bill customers quarterly. On March 31, you've provided two months of service but won't invoice until April 30. With accrual accounting, you record the revenue for those two months in March when you earned it, not April when you send the invoice.

Accrued expenses

Accrued expenses are costs you've incurred but haven't yet paid. This happens when you receive goods or services before the bill comes due.

For example, your employees work the last week of December, but you don't pay them until January 5. With accrual accounting, you record the wage expense in December when employees did the work, not January when you cut the checks.

When to use accrual accounting

Not every business needs accrual accounting, but certain situations make it necessary or beneficial. Here's how to decide which method fits your business:

Accrual accounting is required if:

• Your business is structured as a C-corporation
• Your annual gross receipts exceed $25 million (averaged over 3 years)
• You maintain inventory and have gross receipts over $25 million

Accrual accounting is recommended if:

• You're seeking loans or investment and need professional financial statements
• You sell products and need to track inventory costs accurately
• You have significant accounts receivable or accounts payable
• You're planning to grow and want to avoid switching methods later
• You want a clearer picture of profitability beyond just cash flow

Cash accounting may work better if:

• You're a freelancer or solopreneur with simple finances
• You provide services and get paid quickly
• You want the simplest possible bookkeeping
• Your business is small with minimal receivables and payables

When in doubt, consult with an accountant who understands your business and industry.

How Xero simplifies accrual accounting

Managing accrual accounting manually can be time-consuming, but the right software handles most of the complexity for you.

With automated accrual accounting, you can focus on running your business:

• Automatic tracking: Records receivables and payables as you create invoices and enter bills
• Flexible reporting: Switch between cash and accrual views with one click to see your finances either way
• Real-time visibility: See what customers owe you and what you owe vendors in one dashboard
• Bank reconciliation: Matches transactions automatically so your books stay accurate
• Easy collaboration: Share access with your accountant or bookkeeper without extra software

Whether you're using cash or accrual accounting, you get clear insight into your business finances with Xero. Get one month free and see how you can simplify your accounting.

FAQs on accrual accounting

Here are answers to common questions about accrual accounting for small businesses.

What is a simple example of an accrual?

You receive office supplies in March but don't pay the vendor until April. With accrual accounting, you record the expense in March when you received the supplies, not April when you pay the bill. This matches the cost with the period when you used the supplies.

Are accruals an asset or liability?

It depends on the type. Accrued revenue (money you've earned but haven't received) appears as an asset on your balance sheet. Accrued expenses (costs you've incurred but haven't paid) appear as liabilities.

Do I need to use accrual accounting for my small business?

It depends on your business size, structure, and industry. Some businesses must use accrual accounting, while others benefit from it even when it's not required. Review the "When to use accrual accounting" section above to determine which method fits your situation.

Can I switch from cash to accrual accounting?

Yes, but timing matters. You'll typically need to make the change at the start of a new tax year and may need to file IRS Form 3115 to request the change. Accounting software like Xero supports both methods and makes switching easier.

Does Xero support accrual accounting?

Yes. Xero fully supports accrual accounting and automatically tracks receivables and payables as you create invoices and enter bills. You can also switch between cash and accrual reporting views with one click.