Accrual basis accounting: What it is and how it works

Most businesses start on cash basis accounting because it's simple—revenue in, expenses out, follow the bank. But once you're selling on credit, carrying inventory, or preparing for your first audit, cash basis stops telling the whole story.

Accrual basis accounting fixes that by recording revenue when it's earned and expenses when they're incurred, regardless of when cash actually moves. That timing difference is what gives financial statement readers a clearer view of a company's actual profits and capabilities over a period of time. It also means your income statement can show a profitable month before a single customer payment clears your bank account.

Public companies, regulated businesses, and anyone reporting under generally accepted accounting principles (GAAP) use the accrual method. Most growing companies adopt it well before they're required to because it's the only way to see what a period actually earned.

What is accrual basis accounting?

Accrual basis accounting records revenue when it's earned and expenses when they're incurred, regardless of when cash changes hands. This differs from the cash basis method, which only records transactions when money actually changes hands.

Under accrual accounting, revenue is recorded when earned, not when it's received. Expenses are also recorded when incurred rather than when paid. This method provides an appropriate application of the matching principle under the generally accepted accounting principles.

Under this principle, revenue and expenses should be recognized (or allocated) during the period that they occur. This ensures a more accurate picture of the company's financial performance and position during an accounting period. It matches revenues to the expenses incurred in earning those revenues.

On the other hand, cash basis accounting doesn't necessarily match revenues with related expenses, which can distort a company's true profitability from one period to the next. Accrual basis accounting is considered more reliable and mandatory for regulated and public businesses. Generally, the method of accounting used is indicated in the face of the financial statements.

Accrual basis accounting vs. cash basis accounting

Accrual accounting records revenue and expenses when they're earned or incurred, while cash basis accounting records them only when money moves. That single difference changes what your financial statements say about any given month.

Here's how the two methods compare across the decisions that matter most:

A concrete case makes the gap obvious. A consultant delivers a $5,000 service on Oct. 30 but doesn't get paid until Nov. 25.

Under accrual based accounting, the $5,000 in revenue lands in October, the month the work was done. Under cash basis, it lands in November, when the payment arrives. October looks like a dead month on cash basis even though the consultant earned $5,000.

The core principles of accrual accounting

Two principles do all the work in accrual accounting: revenue recognition and matching. Together they decide which period a dollar belongs to, and they're the reason accrual statements line up revenue with the costs that produced it.

Revenue recognition principle

Under the revenue recognition principle, you record revenue when it's earned, meaning when you deliver the product or service, not when you're paid.

A custom furniture business delivers a finished order in August and receives payment in September. The revenue belongs to August, because that's when the business satisfied its obligation to the customer.

Matching principle

Under the matching princtiple, you record expenses in the same period as the revenue they helped generate.

That same furniture business spent $1,800 on materials and labor to build the August order. Those costs get recorded in August alongside the revenue, so the margin on the job shows up in one place instead of being split across two months.

Key components of accrual basis accounting

The accrual method of accounting differs from cash basis accounting in that revenue and expenses are recognized when they are incurred, not necessarily when cash disbursements or cash receipts have taken place. Four components carry most of that timing work: deferred revenue, accrued revenue, prepaid expenses, and accrued expenses.

Each one exists to park an amount on the balance sheet until it belongs on the income statement.

Deferred revenue

Deferred revenue refers to a company's income where the company has received payment but has not provided any services yet. For example, a software company provides an annual subscription for $12,000 - which is paid upfront. The 12,000 are recorded as deferred revenue and represents a liability since the company has the obligation to provide the services and revenue has not been earned yet. During the annual period, at the end of each month, $1,000 will be recognized as revenue.

On the other hand, if the service has been provided and no payment has been received yet, the amount to be paid is recognized as an "Account receivable" or "Customer receivable" or depending on the company, it can be designated as "Accrued revenue". For example, a landscaping company performs work in December but only invoices the client in January. Though the cash from that job will be received in the new year, the revenue is recognized because the service was offered in the current period.

Here's the same mechanic as journal entries for a $1,200 annual subscription paid upfront.

When you receive the payment:

• Debit Cash $1,200
• Credit Deferred revenue $1,200

Each month, as you deliver the service:

• Debit Deferred revenue $100
• Credit Revenue $100

Accrued revenue

Accrued revenue is income you've earned but haven't yet invoiced or been paid for. It sits on your balance sheet as an asset until the invoice goes out.

Picture this: you complete $300 of consulting work in January and invoice the client in February.

In January, when you finish the work:

• Debit Accrued revenue $300
• Credit Consulting revenue $300

In February, when you issue the invoice:

• Debit Accounts receivable $300
• Credit Accrued revenue $300

Prepaid expenses

Prepaid expenses are payments you make in advance for goods or services you'll use in future periods, and you record them first as an asset. The expense hits your income statement later, as you consume what you paid for.

Say you pay $1,200 in January for 12 months of insurance coverage.

In January, when you pay:

• Debit Prepaid insurance $1,200
• Credit Cash $1,200

Each month of coverage:

• Debit Insurance expense $100
• Credit Prepaid insurance $100

Accrued expenses

Accrued expenses represent costs a company has incurred but has not paid for. A typical example is utilities - the usage during the final weeks of the year incurs an expense, even if the invoice from the utility company has yet to arrive. Other typical accrued expenses include accrued payroll, accrued legal services, interest expense, and taxes.

By recognizing expenses in the period they are incurred, the accrual accounting method provides a more accurate picture of a company's finances for that time frame compared to cash basis reporting.

The critical insight of accrual basis accounting is that revenue and expenses are tied to when the economic activity occurs rather than the associated cash flows. Accrued revenue and accrued expenses allow financial statements prepared under the accrual method to more precisely match revenues with the expenses incurred to earn those revenues.

How accrual basis accounting works

Accrual accounting works by recording revenue when you make the sale or deliver the service, not when the payment arrives. Similarly, expenses are recorded when costs are incurred, not paid.

On the balance sheet, deferred revenue is categorized as a liability since the company has the obligation to deliver on the goods and services. Accounts receivable (accrued revenues) will appear as assets, since the company has earned the right to these revenues but has yet to receive payment. Accrued expenses are current liabilities since the company has consumed resources or utilized services that will require payment soon, such as accrued wages, taxes, and utilities.

Accrual accounting provides a more accurate picture of a company's net income and financial position at a point in time. This is because it ties revenues to efforts expended to generate them and matches expenses to the periods that benefit from those costs. It allows for better investment and business decisions compared to cash-basis accounting. Running a regular cash flow analysis alongside your accrual statements helps you catch the gap between reported profit and actual liquidity before it becomes a problem.

Who has to use accrual basis accounting?

Financial statements prepared under U.S. GAAP must use accrual accounting, so if you report under GAAP, the decision is already made for you. Auditors, lenders, and institutional investors all expect accrual statements.

Tax rules apply a separate test. Under Internal Revenue Code section 448(c), you generally have to use the accrual method of accounting for tax purposes once your average annual gross receipts exceed a set threshold.

For tax years beginning in 2026, that threshold is $32 million in average annual gross receipts over the prior three tax years, according to IRS Rev. Proc. 2025-32. The statutory base amount is $25 million, and it's adjusted for inflation each year under 26 U.S.C. § 448.

Size isn't the only trigger. Carrying inventory or selling on credit generally pulls you into accrual reporting too, because both create receivables, payables, or asset balances that cash basis can't represent.

You'll generally need accrual accounting if:

• Your average annual gross receipts exceed the IRS threshold for the tax year
• You carry inventory and need to match cost of goods sold to the period you sold it
• You make sales on credit and carry accounts receivable
• You report under U.S. GAAP or IFRS for any reason
• Your investors, lenders, or auditors require audited financial statements

Benefits and drawbacks of accrual basis accounting

Accrual basis accounting provides businesses with crucial benefits compared to a cash-only basis. These are some of the advantages of accrual accounting that can be of great help to businesses:

• It provides a more accurate financial picture of a company's performance. By recognizing revenue when earned and expenses when incurred, accrual basis accounting matches revenues to the costs used to generate those revenues.
• It allows for deeper long-term insights into a company's financial health by spreading revenue and expenses over multiple periods. This helps identify trends over time and clear the reporting of any inappropriate lumpiness.
• Financial reports are prepared following established accounting standards, providing consistency across companies. Compliance with GAAP/IFRS enhances the reliability and comparability of financial statements.

The accrual method costs more to run, and it can hide a cash problem in plain sight. Two drawbacks show up most often:

• It's more complex and more expensive to maintain, since it requires adjusting entries, schedules, and closer oversight than tracking bank activity
• It can show profit before the cash arrives, so a business that looks profitable on paper can still hit a cash shortfall

The second one bites hardest. You can report solid net income for the quarter while your bank balance runs thin, simply because customers haven't paid their invoices yet. Understanding your net 60 payment terms and other extended credit arrangements is especially important here, since longer collection windows widen the gap between accrual income and cash on hand.

Here's the trade-off side by side:

Examples of accrual basis accounting

Accrual accounting aims to record accounting transactions at the point in time they occur rather than when payment is made.

For example, a manufacturing company accrues an expense of $50,000 on December 15 for supplies that were delivered but still need to be paid for. While the invoice from the supplier is dated December 15, the company only reimburses the invoice on January 15 of the following year. Under accrual accounting, they record the $50,000 expense on their income statement for December, even though payment will only occur in January. This matches the expense with the period when the raw materials were consumed.

Another example is if the company accrues $75,000 in revenue on that same date for goods shipped to customers but for which payment has yet to be received. While revenue is earned in December, payment will be received in mid-January. Accrual accounting requires the company to recognize the $75,000 in revenue on its December income statement. This matches revenue with the period in which it was earned rather than the period in which cash was collected.

The journal entries for that pattern are short. Say you earn $10,000 in consulting fees in December and collect the payment in January.

In December, when you earn the fees:

• Debit Accounts receivable $10,000
• Credit Service revenue $10,000

In January, when the client pays:

• Debit Cash $10,000
• Credit Accounts receivable $10,000

The December entry is what puts the $10,000 on your accrual basis income statement for the year it was earned.

When to use accrual basis accounting as you grow

Accrual basis accounting is essential for businesses seeking growth and progress. It provides:

• More accurate financial reporting: This reflects a company's financial performance and position over time, allowing for more thoughtful strategic decision-making
• Insight into profitability: Matching revenues to the expenses associated with generating those revenues fuels informed decisions about investments, expansions, and innovations
• Closer alignment of taxable income with financial results: This allows tax planning and liabilities to be forecast more accurately, promoting steady, sustainable organizational development

Timing the switch is the real question. Early-stage startups running a handful of monthly transactions can usually stay on cash basis without losing much, because their revenue and their deposits land in roughly the same month.

You should plan the move once any of these show up: your first audit, a priced funding round, sales on credit terms, inventory on the balance sheet, or gross receipts approaching the IRS threshold above. If you're evaluating accounting software for venture-capital-backed companies, accrual-ready tooling should be a baseline requirement.

Switch before the deadline, not after. Converting mid-audit means rebuilding prior periods under pressure, while converting early lets your team learn the adjusting entries on a quiet close. Volume is the other reason to move early: Glossier auto-codes 90% of its transactions on Ramp, which is the kind of throughput that makes manual period matching impossible to sustain by hand.

Automate accrual accounting and period matching with Ramp

Accrual accounting requires you to match expenses to the period when they're incurred, but tracking timing differences manually is tedious and error-prone. Missing receipts, delayed approvals, and transactions that span multiple periods create gaps that slow down close and introduce risk. Automating invoice scanning and processing is one of the fastest ways to eliminate those gaps at the source.

Ramp's accounting automation software handles accrual accounting automatically, so every expense lands in the right period without manual intervention. When a transaction posts but context is missing—like a receipt that hasn't arrived yet—Ramp posts an accrual to your ERP automatically. Once the missing details come through, Ramp reverses the accrual and syncs the final transaction with full context.

Here's how Ramp automates accrual accounting:

• Auto-post accruals: Ramp identifies transactions missing receipts or approvals and posts accruals automatically so expenses hit the right period
• Auto-reverse when ready: Once context arrives, Ramp reverses the accrual and syncs the complete transaction to your accounting system
• Match across periods: Ramp tracks timing differences and ensures every expense is recorded when incurred, not when paid
• Close with confidence: Your books reflect accurate period matching every month, so close is faster and audit trails are complete

With Ramp, you eliminate manual accrual tracking and close your books 3x faster.

Try a demo to see how Ramp automates accrual accounting from end to end.