A Guide to Accruals Accounting

Accruals accounting is a method of keeping track of business transactions. Using this method, you record the transactions as they happen rather than when cash changes hands. Accruals accounting is a way of recording expenses and revenues in the correct financial period. This makes it easier to understand your company’s financial performance.

There are two main ways to account for income and expenses: the accrual method of accounting and the cash-basis method. The accrual method of accounting records income and expenses when earned or incurred, even if the associated cash transaction has not yet occurred. The cash-basis method only records income and expenses when they are received.

You must choose which system you use before setting up the accounts. When you set up account software, you can select either a cash or accruals basis.

Accruals Accounting Definition

Accrual Accounting adjusts the accounts to record transactions when the occur. The transaction takes place when the goods or services are delivered or received.

How Accruals Work

Accruals record transactions in the period they occur. It is usually done by creating a journal of all the transactions in the accounting system. An example of an accrual is for work completed but not invoiced yet. Or an expense made, but the bill has not been received yet.

The accruals account is part of the balance sheet, while the expenses or sales are posted to the income statement.

Accruals in the Balance Sheet

Use a journal entry form to create an accrual in the balance sheet. A journal entry form is available from the website.

As with all double entry bookkeeping, the accounts will have at least two entries. One will be a debit to an expense account on the income statement, and the balancing item is to the accruals under current liabilities on the balance sheet. See the example of an accrual journal further down.

Reverse the journal entry when the transaction appears in the accounts; otherwise, a duplicate amount is in the reports. Accounting software packages can automatically reverse a journal after the month-end. It will save errors when the accrual and invoice are posted to the system. We recommend using either Sage UK, Xero or QuickBooks as they have good user interfaces and are suitable for self-employed and small businesses.

Accruals Accounting Example

Here are several different examples:

Utilities

The utility company may issue a bill only once a quarter, when they read the meter. It means no transactions will appear in the accounts for the period. Therefore, the accounts need to be adjusted for the accrued expense.

Goods and services

A supplier delivers products or services but does not invoice until the following month. An adjustment is needed in the accounts to include these items; it might be an estimate.

Wages

You may pay salaries to the 26^th of the month and post the additional days of the month using an accrual.

Sales

As a business, you may work on a project for months before issuing the invoice. A sales accrual will be posted to the accounts. Ensure that you also enter any expenses related to the sale. Record it as an asset on the balance sheet.

Taxes

The business incurs taxes, and no bill is received from the tax office. For example, a company has calculated its year-end profits, and corporation tax is due. A journal is, therefore, required to adjust the accrued expenses.

Accruals Accounting vs Cash Accounting

Cash accounting and accrual accounting are two different ways of recording business transactions. Cash accounting records transactions when money changes hands, while accrual accounting records transactions in the period they occur.

The accrual accounting method is more accurate for tracking a business’s financial performance over time.

There are several key differences between cash accounting and accrual accounting. Cash accounting does not accurately show how a business is doing. Accrual accounting allows businesses to see how their current performance compares to their past performance.

Revenue and expenses are only recorded when cash is exchanged under cash accounting. Accrual accounting allows businesses to record revenue and expenses when they occur, which provides a more accurate picture of performance.

Cash transactions are more straightforward for business owners to track than accruals. Accrued balances can sometimes be difficult to calculate.

In accrual accounting, tax is calculated when the transactions have taken place. On cash accounting, it is calculated when cash is received or spent. An example of this is VAT. A VAT sales invoice is issued in one quarter, but payment is received in the second quarter. Accounting using the accrual method means that the VAT is due in the first quarter, but cash accounting is in the second quarter.

It can take longer to prepare financial statements under the accrual accounting method. Accrual accounting does have its benefits, though, as businesses can see their performance over time more accurately.

Most accounting software packages have the option to choose the cash or accrual basis of accounting. Each method has its own advantages, and it’s important to understand their differences before making a decision.

Here is an example:

A company makes a sale in December, but the terms are 30 days. The accrual accounting entries are posted in December, the month of sale. The money is received from the customer in February. The entry is posted when the payment is received in February in cash accounting.

Advantages of Accrual Accounting

There are several advantages of accrual accounting.

It provides a more accurate picture of a business’s financial performance over time. This is because revenue and expenses are recorded when they occur rather than when cash is exchanged. This allows companies to track their current performance against past performance.

It is the standard accounting method used by businesses in the UK. Companies using this method can easily compare their finances to other companies.

If you are looking for a loan or investment, the accruals method is required to see an accurate financial picture on the income statement.

Disadvantages of Accrual Accounting

There are several disadvantages of accrual accounting:

As a business owner, accruals are more complex to understand, and journals must be adjusted to the correct accounting period.

Bookkeepers must track more transactions when using the accruals method. This can make it harder to prepare financial statements.

Accruals Accounting Journal Entry

When recording an accrual in accounting, you must create a journal entry. It will involve adding to at least one account and subtracting from others. The goal is to ensure that the balances of both the additions and subtractions are equal. It is part of double entry bookkeeping.

Below is an example of a journal entry. The entry shows two accruals; the first is for a consultancy invoice not received from the supplier, and the second is for an electricity adjustment. Once the journal is prepared, post it to the accounts at the month or year-end.

	Debit	Credit
Consultancy Expense	500.00
Electricity	120.00
Accruals		620.00
Totals	620.00	620.00

Prepayments vs Accruals

Prepayments differ from accruals in that they are cash payments made in advance for goods or services that have not yet been received; they are prepaid expenses.

On the other hand, accruals are adjustments made to account for revenue and expenses that have been incurred but not yet paid for. Prepayments affect a business’s cash flow because you have already paid for something, while accruals do not because they have not been paid for yet.

Accruals Summary

The main advantage of accrual accounting is that it provides a more accurate picture of its financial position. This is because revenue and expenses are recorded when they occur rather than when cash is exchanged. This method allows companies to compare their finances to other companies.

There are also several disadvantages of accrual accounting. It can be more difficult for bookkeepers to track transactions, and preparing financial statements can take longer under this method.