A Guide to the Accrual Accounting Method: Tips and Examples for SaaS Companies
Accrual accounting is the GAAP-compliant way to maintain your books. If you don’t have the basics of accrual accounting down pat, you risk building a shaky foundation for decision-making across the business. Here’s how to make that foundation rock solid.
One of the core tenets of GAAP is that financial reporting is based on the accrual method of accounting.
Compared to the simpler cash basis accounting method, it’s the best way to provide an accurate view of your company’s financial health and performance.
But even for seasoned finance and accounting professionals, accrual accounting can cause headaches during the month-end close process.
Unless you’re a small business with no intention of scaling, you’ll need to know the ins and outs of accrual accounting to create a strong foundation of financial data for your business. Here’s what you need to know about the accrual method and some examples of how it works.
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What Is the Accrual Accounting Method?
The accrual accounting method is an approach to bookkeeping where you recognize revenue in the period when it is earned and record expenses in the period they’re incurred — not when cash exchanges hands in either case.
This bookkeeping method is the de facto standard for GAAP-compliant companies because accruals adhere to recognition and matching principles laid out by the FASB.
What Is the Purpose of Accrual Accounting?
The main purpose of accrual accounting is to match your expenses to the same period in which those expenses helped generate revenue. And you record your revenue in the period where you delivered the service in the case of SaaS accounting.
This approach to financial reporting is required by GAAP regulators because it offers better visibility into the relationship between revenue and expenses across the income statement, balance sheet, and cash flow statement.
That visibility is what helps investors and regulators understand a company’s profitability and financial health on a granular level.
How Does Accrual Accounting Compare to Cash Accounting?
Accrual accounting is considered the “traditional” method of accounting because it is the GAAP-compliant way to deliver financial reports. Where the accrual method is based on when revenue is earned and when liabilities are incurred, the cash basis method of accounting records transactions entirely based on cash inflows and outflows.
Cash accounting makes reporting easier for bookkeepers because it’s more straightforward than accruals. But because it doesn’t match revenue and expenses within accounting periods, it’s inappropriate for the kinds of companies regulated by GAAP standards.
The concept of prepaid expenses is a good way to think about the difference between accrual and cash accounting. Consider a company that pays upfront for its annual Salesforce licenses. The expense is $25k.
Under cash accounting, you would record the $25k expense in the month you paid the invoice because that is when the cash exchanged hands. But accrual accounting requires you to break that prepaid expense out evenly across the contract length (i.e., accrue the expense for 12 months). In this case, you would record ~$2,083 per month for the year of service.
Because this guide is focused on SaaS accounting for high-growth companies, we’ll go deeper into the accrual method below. But if you’re running a small business and know that the cash basis is right for you, this guide from NetSuite might help.
How Does Accrual Accounting Work?
Accrual accounting works by using the balance sheet to record unrecognized revenue and expenses that haven’t yet been incurred by the business. You then create journal entries to record the revenue and expenses on your income statement as they are recognized/incurred.
In practice, there are a few high-level steps for managing accruals when closing your books:
- Discuss customer contracts with revenue leaders. Creating journal entries for accrued and recognized revenue requires a deep understanding of customer contracts and billing cycles. Communicate with revenue leaders regularly to stay ahead of potential complications with accruals.
- Email vendors about invoices and check in with department heads. The timing of vendor invoices could impact whether or not you capture the full scope of incurred and accrued expenses on financial statements. Send reminders to vendors and check in with department leaders to better understand any potential nuances to their spend.
- Create journal entries for accrued revenue and expenses. Update accounts receivable and accounts payable balances according to whether or not revenue has been recognized or expenses have been incurred.
- Reverse accruals as needed after closing the books. Reversing accruals is the process of zeroing out the accrued expense from the prior month. Accounting teams do this at the start of the new period to balance revenue and expenses.
Accrual Accounting Examples
Accruals have long been one of the biggest pains for accounting because of all the potential nuances and complexities of trying to match revenue and expenses to the periods they’re recognized/incurred. And it’s potentially most painful on the expenses side.
Unless you’re going to go to ask every leader for a list of every vendor they’re working with and plan to start working with each month, there will be surprises along the way. You either end up reporting all expenses in one period because they’ve already happened and you didn’t accrue them. Or, you have to go back and change your books historically. Neither are great options, but they happen all the time.
But it’s more than likely that you know the areas of your business that might have these surprising expenses. Legal is a common example because of its high costs and notoriously delayed billing. In this case, you should have monthly meetings with the head of legal to get ahead of the potentially lumpy spend.
Aside from an edge case like surprise legal expenses, most accruals look more or less similar.
Accrued Revenue — Accounts Receivable
In the case of accrued revenue, there are a few relevant line items on your financial statements to pay attention to.
- Accounts receivable (balance sheet). The balance of recognized revenue that you have billed for, but have not yet collected.
- Deferred revenue (balance sheet). The amount of booked revenue you have that has not yet been recognized. This is a liability on your balance sheet.
- Revenue (income statement). The recognized revenue for the given period.
Let’s walk through a quick example. Say a new customer signs on for a one-year contract worth $12k, running from February 1st of this year to January 1st of the next.
If you invoice them upfront for the first month, you’d record $1k in your accounts receivable balance for the February month-end close. And you’d have $1k in deferred revenue scheduled as an accrual for each month for the length of the contract.
In March when you close the books, you would have $1k of recognized revenue (assuming the customer paid within 30 days), $1k in accounts receivable for the newly-billed month, and $10k remaining in deferred revenue for the life of the contract.
Accrued Expenses — Accounts Payable
Accrued expenses appear in a few key line items on your financial statements.
- Accounts payable (balance sheet). The expenses you’ve been billed for but haven’t yet paid.
- Accrued expenses and other current liabilities (balance sheet). The pool of amortized expenses for any prepaid contracts. For example, if you paid $24k upfront for a year of Salesforce, it would be recorded here and converted to accounts payable and operating expenses as the life of the contract went on.
- Operating expenses and cost of revenue (income statement). Incurred expenses that you’ve paid will appear on the income statement as operating expenses or cost of revenue, depending on how they relate to your business.
An example could be the monthly hosting costs for your SaaS product. You pay monthly according to your usage of a platform like AWS.
Say you received a bill on February 28th for $12k from the previous period’s usage. In this case, you would record $12k in your accounts payable balance when closing the books on February. Since you pay monthly, the accrued expenses line item won’t come into play. And once you pay the invoice, that $12 comes out of your accounts payable balance and appears in your cost of revenue when you close the books in March.
Accrual Accounting FAQs
What does accrual mean?
In accounting, the term “accrual” refers to revenue and expenses that has been earned or agreed upon, but has not yet been recognized or paid.