What is accrual accounting?

What is accrual accounting?

Accrual and cash accounting are the two primary tax accounting methods.

Using the accrual accounting method, revenue or expenses are recorded when a transaction occurs rather than when payment is received or made. This means income is recognised as soon as an invoice is raised, and an expense is recognised as soon as a bill comes in, even if payment won’t be made until a later date.

Cash accounting, on the other hand, is whereby transactions are only recognised when payment is made.

How accrual accounting works

To understand accrual accounting, it’s important to be clear about what actually constitutes an accrual in accounting. Accruals refer to adjustments that have to be made before a company's financial statements are issued. They involve expenses, losses and liabilities that have been incurred but are not yet recorded in the accounts, and revenues and assets that have been earned but not previously recorded.

The purpose of accrual accounting, therefore, is to match revenues and expenses to the time periods in which they were incurred – the matching principle – as opposed to the timing of the actual cash flows related to them. Accruals help to represent the underlying economic reality of a transaction.

It is a particularly useful method in those businesses where there are a lot of credit transactions; for example when goods and services are sold on credit rather than exchanging cash. 

In broad terms, accruals in accounting fall into two categories, revenues (receivables) and expenses (payables).

Accrued revenues

Accrued revenues are income or assets (including non-cash assets) that are yet to be received. In this case, a company may provide a service or deliver goods, but on credit. Consider a contractor that issues an invoice for £1,000 at the start of the month, but is only paid 30 days later. According to accrual accounting, the revenue will be recognised when the invoice is issued, rather than when it is paid. Accrual accounting, therefore, gives the business a means of tracking its financial position more accurately by acknowledging the future income it expects to receive.

Accrued revenues are typically shown as a current asset on the balance sheet, until such time as they are paid.

Using the above example, the following journal entry would be created when the invoice is issued:

  • Debit Accounts Receivable (Current Asset): £1,000
  • Credit Sales Income (Revenue account): £1,000

When the invoice is paid 30 days later, then the following journal would be entered:

  • Debit Bank Account (Current Asset): £1,000
  • Credit Accounts Receivable (Current Asset): £1,000

As you can see, the net effect of the above at the end of the financial period is that the Debit and Credit to Accounts Receivable would cancel each other out, and the business would be left with the following balances in the Trial Balance:

  • Debit Bank Account: £1,000
  • Credit Sales Income: £1,000

Accrued expenses

An accrued expense is an expense that is recognised on the books when it is incurred, rather than when it is paid. Because accrued expenses represent a company's obligation to make future cash payments, they are shown on the balance sheet as a current liability.

Common accrued expenses include interest expenses that are owed but unpaid; operating expenses for goods or services from a third-party supplier; tax due; and wage or salary accruals.

As an example, consider the case when a business receives an invoice for £50 electricity, payable in 15 days:

  • Debit Electricity (Expenses account): £50
  • Credit Accounts Payable (Current Liability): £50

When the electricity is paid 15 days later, then the following journal would be entered:

  • Debit Accounts Payable (Current Liability): £50
  • Credit Bank Account (Current Asset): £50

The net effect on the Trial Balance at the end of the financial period of the above is the following:

  • Debit Electricity: £50
  • Credit Bank Account: £50

Prepaid expenses vs accrued expenses

Accrued expenses should not be confused with prepaid expenses. Prepaid expenses are payments made in advance for goods and services that are expected to be provided or used in the future. While accrued expenses represent liabilities, prepaid expenses are recognised as assets on the balance sheet.

As an example, if you prepay for your website hosting fees for the full year, then this would be recorded in the financial statements as follows.

  • Debit Prepaid Expenses (Current Asset): £360
  • Credit Bank Account (Current Asset): £360

At the end of each month, the accrued part of the expense would be allocated as follows:

  • Debit Website Hosting (Expenses): £30
  • Credit Prepaid Expenses (Current Asset): £30

Accordingly, by the end of the 12th month, the prepaid expense account would be fully allocated, leaving the following balances in the Trial Balance: Debit Website Hosting (Expenses): £360 Credit Bank Account (Current Asset): £360

The advantages and disadvantages of accrual accounting

Advantages

  • Creates a more accurate picture of a business’ performance and finances
  • Helps the business to make better-informed financial decisions
  • Can make it easier to get long-term finance (most lenders and investors will require that your financial statements are prepared according on the accrual basis).

Disadvantages

  • It can be more complex and involve closer monitoring of invoices
  • Tax has to be paid on income before the customer has actually settled the amount. This may result in short term cash flow issues. (Note that if your customer does not pay the invoice, then you can claim the tax back on a future return).

Should I use accrual or cash accounting?

Most small businesses in the UK with an income of £150,000 or less can use the cash basis for reporting, so they will only record income or expenses when they receive money or pay a bill. This means they will not need to pay income tax on money that has not yet been received in each accounting period. It may also make it easier to create your financial statements simply by looking at the incomings and outgoings from the business bank account.

However, according to HMRC, cash accounting probably won’t be suitable for companies that want to claim interest or bank charges of more than £500 as an expense; that are more complex (for example holding high levels of stock); or that need to source finance for their business. It also won’t be suitable for companies that plan to offset losses against other taxable income.

In fact, many small businesses would benefit from accrual accounting, placing them in a better position for when the business grows and making it easier to accurately measure the financial performance of the business. Also, some traditional lenders won’t deal with businesses using cash accounting, so using accrual accounting could help them to obtain any finance that they may need.

Whatever the size of your company, accrual accounting usually gives a better indication of business performance because it shows when the underlying income and expenses occurred.

Having said that, accrual accounting can be more complex and require more work. And it’s here that your accounting software can make a difference, much simplifying a potentially time-consuming task. Whether you want to make the switch from cash to accrual or you want to reduce the burden associated with accrual accounting, AccountsPortal can help.

To find out how, please get in touch with us via our support pages.


Further Reading

How to Manage Overdue Invoices

An Introduction to Invoices

How to generate a Credit Note in your accounting software