Accounting accruals are adjusting entries that record revenue you have earned but not yet collected and expenses you owe but have not yet paid. They exist so your income statement and balance sheet reflect what the business actually did during a period, rather than the accidents of when checks cleared. If your books only move when cash moves, a strong month of work followed by slow-paying clients looks like a bad month, and a month where you prepaid a year of insurance looks like a disaster. Accruals fix that.
What Accruals Do
Under the cash basis, a transaction hits the books only when money moves. Record revenue when the customer pays; record expenses when the check clears. Simple, and workable for many sole proprietors.
Accrual accounting works differently. You record revenue when you earn it and expenses when you incur them, regardless of when cash changes hands. A consulting firm that finishes a $10,000 project phase on December 28 records that revenue in December, even if the client does not pay until February. A business that receives a shipment of supplies on December 30 records the expense in December, even though the invoice is not due until January 15. The financial statements then show what the business actually did, not what happened to flow through the bank account.
The IRS also permits a hybrid method that combines both. A business that carries inventory, for example, can use accrual for purchases and sales while using cash for everything else, as long as the combination clearly reflects income and is applied consistently.1Internal Revenue Service. Publication 538 – Accounting Periods and Methods
The Four Types of Accruals
Every accrual entry addresses one of four timing gaps between economic activity and cash flow.
Accrued Revenue
Accrued revenue is income you have earned but not yet billed or collected. A law firm that logs 40 billable hours in the last week of March but sends the invoice in April has accrued revenue for those hours. The firm records an asset (often called Accrued Receivables) and revenue on the income statement, keeping March’s numbers honest.
Accrued Expenses
Accrued expenses are costs you have incurred but not yet paid. Wages are the most common example. If a pay period ends on the 25th but the accounting period closes on the 31st, employees have earned six days of pay that payroll has not processed yet. Interest works the same way: it accrues daily, but the lender may only bill monthly. Recording these costs as liabilities keeps you from overstating profit.
Deferred Revenue
Deferred revenue, sometimes called unearned revenue, is the mirror image. The customer has already paid; you have not yet delivered. A software company that sells annual subscriptions collects the full year’s fee upfront but records it as a liability. Each month, as the company delivers access, it moves one-twelfth into revenue. Without this treatment, the company would look wildly profitable in the month of sale and unprofitable for the eleven months of actual service.
Prepaid Expenses
Prepaid expenses reverse the accrued-expense pattern. You have paid cash for something you have not yet consumed. Pay a twelve-month insurance premium in January, and only one month of coverage is used by month-end. The remaining eleven months sit on the balance sheet as an asset, and each month you recognize one-twelfth as expense. Skip this step, and January absorbs the entire annual cost while the other eleven months show none.
Estimated Liabilities
Some accruals involve real uncertainty about the amount. Product warranties are the classic case. When a manufacturer sells a product with a two-year warranty, historical data tells it some percentage of buyers will file claims. Under generally accepted accounting principles, the company must accrue a warranty liability at the time of sale if two conditions are met: claims are probable, and the amount can be reasonably estimated.2Financial Accounting Standards Board. Summary of Statement No. 5 Companies base these estimates on their own claims history or, for new products, on industry data from similar businesses. Income tax accruals follow the same logic: a business does not wait until April to book the tax on last year’s income, but estimates and records the liability throughout the year.
How the Journal Entries Work
The mechanics follow a consistent pattern. Every accrual entry uses one debit and one matching credit, linking the income statement to the balance sheet.
For accrued revenue, debit an asset account (Accrued Receivables) and credit a revenue account. For accrued expenses, reverse the pattern: debit an expense account (wages expense, interest expense) and credit a liability account (Accrued Liabilities or Accrued Wages Payable).
Deferred revenue starts from cash. When the customer pays upfront, debit cash and credit Unearned Revenue, a liability. As you deliver the service, debit Unearned Revenue and credit revenue. Prepaid expenses run the same way in reverse: debit a Prepaid asset when you pay, then debit expense and credit the Prepaid asset as you consume what you bought.
Reversing Entries
Most accrual entries get reversed on the first day of the next accounting period. Without the reversal, you risk double-counting when the actual invoice arrives and is processed normally. If you accrue $5,000 in wages on December 31 and reverse the entry on January 1, the January payroll run records those wages in the ordinary course without anyone needing to remember to subtract the accrual by hand. Skipping the reversal is one of the most common sources of error in accrual books.
Cut-off at Period-End
Timing is where accrual accounting gets practical. At close, the finance team has to decide which invoices, shipments, and service deliveries belong to the current period and which belong to the next. That means reviewing receiving reports, checking shipping dates, and confirming whether services were actually performed before the close date. An invoice dated December 28 for goods that did not arrive until January 3 belongs in January. Auditors look at cut-off decisions first, because getting them wrong shifts revenue or expense into the wrong period.
When Revenue Is Earned
Two principles drive the timing of accrual entries: revenue recognition and expense matching.
The current U.S. standard for revenue recognition is ASC 606. It uses a five-step framework that starts with identifying the contract, breaks the contract into distinct performance obligations, sets the total transaction price, allocates that price across the obligations, and recognizes revenue only as each obligation is satisfied and the customer obtains control of what was promised.3Financial Accounting Standards Board. Revenue from Contracts with Customers Topic 606 The international equivalent, IFRS 15, uses the same structure and produces largely similar outcomes.4IFRS Foundation. IFRS 15 Revenue from Contracts with Customers The central idea is simple: you do not record revenue until you have done what you promised.
The matching principle then requires that expenses appear on the income statement in the same period as the revenue they helped generate. A contractor who spends $2,000 on materials to complete a $15,000 job in March records both the cost and the revenue in March. Split them across periods and profitability distorts in both directions. This linkage is why accruals exist. Without them, expenses and the revenue they produce drift apart based on nothing more than when checks were written.
Materiality and Documentation
Not every minor timing difference justifies an accrual entry. Businesses set internal policies about when an amount is large enough to record. A $47 utility bill spanning two months rarely warrants an adjustment; a $200,000 progress billing on a construction project always does.
The SEC has been clear, however, that no magic percentage automatically makes a misstatement immaterial. Staff Accounting Bulletin No. 99 explicitly rejected using a fixed threshold, such as 5% of net income, as the sole test. Materiality depends on whether a reasonable person would consider the information important, which means looking at both the dollar amount and the context.5U.S. Securities and Exchange Commission. Staff Accounting Bulletin No. 99 – Materiality A quantitatively small misstatement can still be material if it masks a change in earnings trends, turns a loss into a profit, affects loan covenants, or increases management compensation.
Accrual entries are only as good as the information behind them. Before closing the books, the finance team typically gathers time logs and project records to identify unbilled services, reviews payroll schedules to calculate wages earned since the last payday, pulls utility and vendor records to estimate costs not yet invoiced, and examines loan agreements to compute accrued interest. Each data point feeds an accrual worksheet documenting the date incurred, the estimated amount, and the vendor or customer involved. Vague estimates without supporting documentation cause problems in external reviews. Even for warranty and similar estimates, auditors expect to see the historical data and methodology used to arrive at the number.
Where Accruals Get Abused
Because accruals involve estimates and judgment, they are one of the easiest areas of accounting to manipulate. The most common tactic is building up excessive reserves during good years and quietly releasing them into income during bad ones, sometimes called “cookie jar” accounting. It smooths earnings in a way that misleads investors about the company’s actual trajectory. The Securities Exchange Act of 1934 gives the SEC authority to bring civil enforcement actions and impose fines against companies and individuals for accounting fraud.6Legal Information Institute. Securities Exchange Act of 1934 The practical guardrail is straightforward: accrual estimates should be grounded in verifiable data and applied consistently, and a methodology that changes from quarter to quarter without a clear business reason is exactly the pattern that draws scrutiny.
Who Is Required to Use Accrual Accounting
Federal tax law does not leave the choice entirely open. Under Section 448 of the Internal Revenue Code, C corporations, partnerships that include a C corporation as a partner, and tax shelters generally cannot use the cash method and must compute taxable income on the accrual basis.7Office of the Law Revision Counsel. 26 USC 448 – Limitation on Use of Cash Method of Accounting
There is an important exception. A C corporation or qualifying partnership can still use cash-basis accounting if its average annual gross receipts for the prior three tax years do not exceed the inflation-adjusted threshold. For tax years beginning in 2026, that threshold is $32 million.8Internal Revenue Service. Revenue Procedure 2025-32 Once you cross that line, you must switch to accrual for the tax year in which you fail the test.1Internal Revenue Service. Publication 538 – Accounting Periods and Methods
Businesses that produce, purchase, or sell merchandise face a separate rule: inventories are generally required to reflect income correctly, and inventory accounting uses the accrual method for purchases and sales. Small business taxpayers that meet the same $32 million gross receipts test can opt out and treat inventory as non-incidental materials and supplies instead.9eCFR. 26 CFR 1.471-1 – Need for Inventories A change in method, whether voluntary or forced by failing the gross receipts test, is made by filing IRS Form 3115 with the return for the year of change.10Internal Revenue Service. Instructions for Form 3115