The accrual principle of accounting is a methodology used to measure business transactions. Under this principle, income and expenses are recognized as they occur, not when money changes hands. It's a method more complex than cash basis, and it is required of corporations with sales of $5 million and over in the United States.
GAAP, the official accounting guidance in the U.S., stands for "generally accepted accounting principles." Per GAAP, the accrual method is the accepted basis of accounting because it matches income and expenses on a timely matter, making financial reports more useful and reliable. The accrual basis is also the only method accepted by the Securities and Exchange Committee for public firms.
The accrual basis is reflected in the income with the setup of accounts receivable, deferred revenue and accrued revenue. Accounts receivable are recognized as income when they are created. Deferred revenue reflects funds that have been received for a project in the future. An example of this type of transaction is a deposit received by a school to be used in a following fiscal year, when school starts. The deposit is not recognized now as income, but it will be in the following fiscal year.
Accrued revenue relates to income not yet recognized as a receivable; often the case with projects finished this year but not yet invoiced. Accrued revenue is recognized as income in the period the work is done.
Expenses in the accrual basis are recognized as the expenses occur -- not when items are paid. Practically, when an invoice is entered in the accounting system an expense is created in the general ledger. A common procedure at the end of a period is to search for expenses that are paid in the following period but belong to this period. For example, utilities are often paid in the beginning of the following month and are often accrued in the month they occur -- not when they are paid. Another feature of accrual accounting in the expenses area is the prepaid expense item. This account is used when payments occur for events happening in the future -- for instance, a fee to attend a conference months in advance.
Financial statements prepared under the accrual basis shows receivables, payables, accruals, deferrals, depreciation and amortization expenses. Depending on the business type, you may also see inventories and cost of goods sold. Financial statements prepared under the accrual method are often reliable and comparable to other businesses. Under the cash method, for example, revenues and expenses can be manipulated by timing when money is received or paid out. This doesn't happen with accrual basis.
The accrual principle of accounting is often the only method accepted by banks and investors. It is also the only basis accepted by the Securities and Exchange Commission regarding public companies. Accrual can be more complex than cash basis, but it carries many benefits, such as the ease in planning for the future and getting a realistic financial view of a firm.