What is accrual accounting?

Accrual accounting records revenue when earned and expenses when incurred, regardless of when cash changes hands. For professional service firms, this means recognizing $80,000 revenue in October when a project completes, even if the invoice isn't sent until November and payment arrives in December. Similarly, a $5,000 software bill received December 31st is recorded as December expense, even if paid January 15th. Accrual accounting provides accurate monthly profitability measurement by matching revenue with related expenses in the same period.

Key characteristics of accrual accounting

• Required for: C-Corps, businesses over $25M revenue, companies with inventory

• Creates: Accounts receivable (revenue earned, not paid) and accounts payable (expenses incurred, not paid)

• Matches: Revenue with expenses in the period they occur

• Differs from cash basis: Cash basis records transactions only when money moves

• More complex: Requires revenue recognition, accrued expenses, deferred revenue tracking

Why accrual accounting matters for service firms

Accrual accounting reveals true business performance. A consulting firm using cash basis might show $0 revenue in December (no payments received) despite delivering $200,000 in services, then show $400,000 revenue in January when clients pay for December and January work. This volatility masks actual performance. Accrual basis would show $200,000 December revenue and $200,000 January revenue, accurately reflecting service delivery. Most professional service firms over $1M revenue use accrual basis for accurate management reporting, even if they file taxes on cash basis (if under $25M).

Example: Cash vs accrual accounting comparison

          Consulting firm activity in December:

• Services delivered: $180,000

• Expenses incurred: $120,000 (payroll, contractors, rent, software)

• Cash received from November invoices: $95,000

• Cash paid for November expenses: $88,000
  
  Cash basis December financials:

• Revenue: $95,000 (cash received)

• Expenses: $88,000 (cash paid)

• Net income: $7,000
  
  Accrual basis December financials:

• Revenue: $180,000 (services delivered)

• Expenses: $120,000 (expenses incurred)

• Net income: $60,000

• Reality: The firm had a strong month ($60K profit), but cash basis shows only $7K profit because payment timing lagged service delivery. Accrual basis accurately shows the $60,000 earned in December.

• This matters for: Hiring decisions (can we afford a new consultant?), pricing analysis (are we profitable?), performance tracking (are we meeting targets?)