What Is Accrual Accounting?

Accrual accounting is a financial accounting method that allows a company to record revenue before receiving payment for goods or services sold and record expenses as they are incurred.

In other words, the revenue earned and expenses incurred are entered into the company’s journal regardless of when money exchanges hands. Accrual accounting is usually compared to cash basis of accounting, which records revenue when the goods and services are actually paid for.

Learn more about accrual accounting and how it differs from the other popular accounting method, cash accounting.

How Accrual Accounting Works

The general concept of accrual accounting is that accounting journal entries are made when a good or service is provided rather than when payment is made or received. Entries are also made for debts and payments due.

This method allows the current and future cash inflows or outflows to be combined to give a more accurate picture of a company’s current and long-term finances.

Accrual accounting follows the matching principal, which states that revenues and expenses should be recorded in the same period.

Accrual accounting is encouraged by International Financial Reporting Standards(IFRS) and Generally Accepted Accounting Principles (GAAP). As a result, it has become the standard accounting practice for most companies except for very small businesses and individuals.

Qualifying for Accrual Accounting

Larger companies are required to use the accrual method of accounting if their average gross receipt of revenues is more than $25 million over the previous three years. If a company does not meet the average revenue requirement, it can choose to use cash basis or accrual as its accounting method.

Accrual accounting is always required for companies that carry inventory or make sales on credit, regardless of the company size or revenue.

Benefits of Accrual Accounting

The accrual method does provide a more accurate picture of the company’s current condition, but its relative complexity makes it more expensive to implement.

This method arose from the increasing complexity of business transactions and a desire for more accurate financial information. Selling on credit, and projects that provide revenue streams over a long period, affect a company’s financial condition at the time of a transaction. Therefore, it makes sense that such events should also be reflected in the financial statements during the same reporting period that these transactions occur.

Under accrual accounting, firms have immediate feedback on their expected cash inflows and outflows, making it easier for businesses to manage their current resources and plan for the future.

Accrual Accounting vs. Cash Accounting

Accrual accounting can be contrasted with cash accounting, which recognizes transactions only when there is an exchange of cash. Additionally, cash basis and accrual differ in the way and time transactions are entered.

Cash Basis of Accounting

Cash accounting uses transactions when payments are made. For example, consider a consulting company that provides a $5,000 service to a client on Oct. 30. The client received the bill for services rendered and made a cash payment on Nov. 25. Under the cash basis method, the consultant would record an owed amount of $5,000 by the client on Oct. 30, and enter $5,000 in revenue when it is paid on Nov. 25 and record it as paid.

Accrual Basis of Accounting

In contrast, accrual accounting uses a technique called double-entry accounting. When the consulting company provided the service, it would enter a debit of $5,000 in accounts receivable (debits increase an asset account). When the payment is made on Nov. 25, the consultant credits (credits decrease an asset account) the accounts receivable by $5,000 and credits the service revenues account, a revenue account (credits increase a revenue account ) with $5,000.

The received capital can then be moved to other accounts, such as free cash, if needed—the company uses the same double-entry method to enter which account the capital came from and is moved to.

The Bottom Line

Accrual accounting is an accounting method in which payments and expenses are credited and debited when earned or incurred. Accrual accounting differs from cash basis accounting, where expenses are recorded when payment is made and revenues recorded when cash is received.

Accrual accounting uses double-entry accounting, where there are generally two accounts used when entering a transaction. This method is more accurate than cash basis accounting because it tracks the movement of capital through a company and helps it prepare its financial statements.

What Is Accretion?

Accretion is the gradual and incremental growth of assets and earnings due to business expansion, a company’s internal growth, or a merger or acquisition. 

In finance, accretion is also the accumulation of the additional income an investor expects to receive after purchasing a bond at a discount and holding it until maturity. The most well-known applications of financial accretion include zero-coupon bonds or cumulative preferred stock.

Understanding Accretion

In corporate finance, accretion is the creation of value through organic growth or through a transaction. For example, when new assets are acquired at a discount or for a cost that is below their perceived current market value (CMV). Acccretion can also occur by acquiring assets that are anticipated to grow in value after the transaction.

In securities markets, purchasing bonds below their face or par value is considered buying at a discount, whereas purchasing above the face value is known as buying at a premium. In finance, accretion adjusts the cost basis from the purchase amount (discount) to the anticipated redemption amount at maturity. For example, if a bond is purchased for an amount totaling 80% of the face amount, the accretion is 20%.

Factoring in Bond Accounting

As interest rates increase, the value of existing bonds declines, which means that bonds trading in the market decline in price to reflect the interest rate increase. Since all bonds mature at the face amount, the investor recognizes additional income on a bond purchased at a discount, and that income is recognized using accretion.

Bond Accretion (Finance)

The rate of accretion is determined by dividing the discount by the number of years in the term. In the case of zero coupon bonds, the interest acquired is not compounding. While the bond’s value increases based on the agreed-upon interest rate, it must be held for the agreed-upon term before it can be cashed out.

Assume that an investor purchased a $1,000 bond for $860 and the bond matures in 10 years. Between the bond’s purchase and maturity dates, the investor needs to recognize additional income of $140. When the bond is purchased, the $140 is posted to a discount on the bond account. Over the next 10 years, a portion of the $140 is reclassified into the bond income account each year, and the entire $140 is posted to income by the maturity date.

Earnings Accretion (Accounting)

The earnings-per-share (EPS) ratio is defined as earnings available to common shareholders divided by average common shares outstanding, and accretion refers to an increase in a firm’s EPS due to an acquisition.

Examples of Accretion

For example, assume that a firm generates $2,000,000 in available earnings for common shareholders and that 1,000,000 shares are outstanding; the EPS ratio is $2. The company issues 200,000 shares to purchase a company that generates $600,000 in earnings for common shareholders. The new EPS for the combined companies is computed by dividing its $2,600,000 earnings by 1,200,000 outstanding shares, or $2.17. Investment professionals refer to the additional earnings as accretion due to the purchase.

As another example, if a person purchases a bond with a value of $1,000 for the discounted price of $750 with the understanding it will be held for 10 years, the deal is considered accretive. The bond pays out the initial investment plus interest. Depending on the type of bond purchase, interest may be paid out at regular intervals, such as annually, or in a lump sum upon maturity. If the bond purchase is a zero-coupon bond, there is no interest accrual.

Instead, it is purchased at a discount, such as the initial $750 investment for a bond with a face value of $1,000. The bond pays the original face value, also known as the accreted value, of $1,000 in a lump sum upon maturity.

A primary example within corporate finance is the acquisition of one company by another. First, assume the earnings per share of Corporation X is listed as $100, and earnings per share of Corporation Y is listed as $50. When Corporation X acquires Corporation Y, Corporations X’s earnings per share increase to $150. This deal is 50% accretive due to the increase in value.

However, sometimes, long-term debt instruments, like car loans, become short-term instruments when the obligation is expected to be fully repaid within one year. If a person takes out a five-year car loan, the debt becomes a short-term instrument after the fourth year.

What Is an Accredited Investor?

An accredited investor is an individual or a business entity that is allowed to trade securities that may not be registered with financial authorities. They are entitled to this privileged access by satisfying at least one requirement regarding their income, net worth, asset size, governance status, or professional experience.

In the U.S., the term accredited investor is used by the Securities and Exchange Commission (SEC) under Regulation D to refer to investors who are financially sophisticated and have a reduced need for the protection provided by regulatory disclosure filings. Accredited investors include high-net-worth individuals (HNWIs), banks, insurance companies, brokers, and trusts.

Understanding Accredited Investors

Accredited investors are legally authorized to purchase securities that are not registered with regulatory authorities like the SEC. Many companies decide to offer securities to this class of accredited investors directly. Because this decision allows companies exemption from registering securities with the SEC, it can save them a lot of money.

This type of share offering is referred to as a private placement. It has the potential to present these accredited investors with a great deal of risk. Therefore authorities need to ensure that they are financially stable, experienced, and knowledgeable about their risky ventures.

When companies decide to offer their shares to accredited investors, the role of regulatory authorities is limited to verifying or offering the necessary guidelines for setting benchmarks to determine who qualifies as an accredited investor. Regulatory authorities help determine if the applicant possesses the necessary financial means and knowledge to take the risks involved in investing in unregistered securities.

Accredited investors also have privileged access to venture capital, hedge funds, angel investments, and deals involving complex and higher-risk investments and instruments.

Requirements for Accredited Investors

The regulations for accredited investors vary from one jurisdiction to the other and are often defined by a local market regulator or a competent authority. In the U.S, the definition of an accredited investor is put forth by SEC in Rule 501 of Regulation D.

To be an accredited investor, a person must have an annual income exceeding $200,000 ($300,000 for joint income) for the last two years with the expectation of earning the same or a higher income in the current year. An individual must have earned income above the thresholds either alone or with a spouse over the last two years. The income test cannot be satisfied by showing one year of an individual’s income and the next two years of joint income with a spouse.

A person is also considered an accredited investor if they have a net worth exceeding $1 million, either individually or jointly with their spouse. This amount cannot include a primary residence. The SEC also considers a person to be an accredited investor if they are a general partner, executive officer, or director for the company that is issuing the unregistered securities.

An entity is considered an accredited investor if it is a private business development company or an organization with assets exceeding $5 million. Also, if an entity consists of equity owners who are accredited investors, the entity itself is an accredited investor. However, an organization cannot be formed with the sole purpose of purchasing specific securities.

Recent Changes to the Accredited Investor Definition

Recently, the U.S. Congress modified the definition of an accredited investor to include registered brokers and investment advisors.

On Aug. 26, 2020, the U.S. Securities and Exchange Commission amended the definition of an accredited investor. According to the SEC’s press release, “the amendments allow investors to qualify as accredited investors based on defined measures of professional knowledge, experience or certifications in addition to the existing tests for income or net worth. The amendments also expand the list of entities that may qualify as accredited investors, including by allowing any entity that meets an investments test to qualify.”

Among other categories, the SEC now defines accredited investors to include the following: individuals who have certain professional certifications, designations, or credentials; individuals who are “knowledgeable employees” of a private fund; and SEC- and state-registered investment advisors.

Purpose of Accredited Investor Requirements 

Any regulatory authority of a market is tasked with both promoting investment and safeguarding investors. On one hand, regulators have a vested interest in promoting investments in risky ventures and entrepreneurial activities because they have the potential to emerge as multi-baggers in the future. Such initiatives are risky, may be focused on concept-only research and development activities without any marketable product, and may have a high chance of failure. If these ventures are successful, they offer a big return to their investors. However, they also have a high probability of failure.

On the other hand, regulators need to protect less-knowledgeable, individual investors who may not have the financial cushion to absorb high losses or understand the risks associated with their investments. Therefore, the provision of accredited investors allows access for both investors who are financially well-equipped, as well as investors who are knowledgeable and experienced.

There is no formal process for becoming an accredited investor. Rather, it is the responsibility of the sellers of such securities to take a number of different steps in order to verify the status of entities or individuals who wish to be treated as accredited investors. 

Individuals or parties who want to be accredited investors can approach the issuer of the unregistered securities. The issuer may ask the applicant to respond to a questionnaire to determine if the applicant qualifies as an accredited investor. The questionnaire may require various attachments: account information, financial statements, and a balance sheet to verify the qualification. The list of attachments can extend to tax returns, W-2 forms, salary slips, and even letters from reviews by CPAs, tax attorneys, investment brokers, or advisors. Additionally, the issuers may also evaluate an individual’s credit report for additional assessment.

Example of an Accredited Investor

For example, suppose there is an individual whose income was $150,000 for the last three years. They reported a primary residence value of $1 million (with a mortgage of $200,000), a car worth $100,000 (with an outstanding loan of $50,000), a 401(k) account with $500,000, and a savings account with $450,000. While this individual fails the income test, they are an accredited investor according to the test on net worth, which cannot include the value of an individual’s primary residence. Net worth is calculated as assets minus liabilities.

This person’s net worth is exactly $1 million. This involves a calculation of their assets (other than their primary residence) of $1,050,000 ($100,000 + $500,000 + $450,000) less a car loan equaling $50,000. Since they meet the net worth requirement, they qualify to be an accredited investor.

The Bottom Line

The accredited investor rules are designed to protect potential investors with limited financial knowledge from risky ventures and losses they may be ill equipped to withstand. But on the flip side, it gives people already starting off with large financial assets a major advantage over those with more modest assets.

What Are Accounts Receivable (AR)?

Accounts receivable (AR) are the balance of money due to a firm for goods or services delivered or used but not yet paid for by customers. Accounts receivable are listed on the balance sheet as a current asset. Any amount of money owed by customers for purchases made on credit is AR.

Understanding Accounts Receivable

Accounts receivable refer to the outstanding invoices that a company has or the money that clients owe the company. The phrase refers to accounts that a business has the right to receive because it has delivered a product or service. Accounts receivable, or receivables, represent a line of credit extended by a company and normally have terms that require payments due within a relatively short period. It typically ranges from a few days to a fiscal or calendar year.

Companies record accounts receivable as assets on their balance sheets because there is a legal obligation for the customer to pay the debt. They are considered a liquid asset, because they can be used as collateral to secure a loan to help meet short-term obligations. Receivables are part of a company’s working capital.

Furthermore, accounts receivable are current assets, meaning that the account balance is due from the debtor in one year or less. If a company has receivables, this means that it has made a sale on credit but has yet to collect the money from the purchaser. Essentially, the company has accepted a short-term IOU from its client.

Accounts Receivable vs. Accounts Payable

When a company owes debts to its suppliers or other parties, these are accounts payable. Accounts payable are the opposite of accounts receivable. To illustrate, imagine Company A cleans Company B’s carpets and sends a bill for the services. Company B owes them money, so it records the invoice in its accounts payable column. Company A is waiting to receive the money, so it records the bill in its accounts receivable column.

Benefits of Accounts Receivable

Accounts receivable are an important aspect of a business’s fundamental analysis. Accounts receivable are a current asset, so it measures a company’s liquidity or ability to cover short-term obligations without additional cash flows. 

Fundamental analysts often evaluate accounts receivable in the context of turnover, also known as accounts receivable turnover ratio, which measures the number of times a company has collected on its accounts receivable balance during an accounting period. Further analysis would include assessing days sales outstanding (DSO), the average number of days that it takes to collect payment after a sale has been made.

Example of Accounts Receivable

An example of accounts receivable includes an electric company that bills its clients after the clients received the electricity. The electric company records an account receivable for unpaid invoices as it waits for its customers to pay their bills. 

Most companies operate by allowing a portion of their sales to be on credit. Sometimes, businesses offer this credit to frequent or special customers that receive periodic invoices. The practice allows customers to avoid the hassle of physically making payments as each transaction occurs. In other cases, businesses routinely offer all of their clients the ability to pay after receiving the service.