A Guide to Accruals Accounting
Accruals accounting is a way 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 how your company is doing financially.
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 when the transaction takes place. The transaction takes place when the goods or services are delivered or received.
How Accruals Work
Accruals work by recording transactions in the period they happen. It is usually done by creating a journal of all the transactions in the accounting system. An example of an accrual would be for some 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 expense 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 QuickBooks or Xero 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 only issue a bill once a quarter when they read the meter. It will mean that no transaction will show 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 26th 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 how they are performing 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 on credit in December, but the sales are on credit terms of 30 days. The accrual accounting entries are posted on the month of sale of December. 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 complicated to understand, and journals must adjust to the correct accounting period.
Bookkeepers have to keep track of 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 are different from accruals in that they are a form of cash payment 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 keep track of transactions, and it can take longer to prepare financial statements under this method.
