Accrual accounting: 3 things to know
The rules which a company follows when recording and reporting its income and expenditure is known as the “accounting method”. There are two main accounting methods: cash accounting and accrual accounting. Governments may require businesses of a certain size or operating in a certain sector to report their financial transactions according to a specific accounting method. It is essential to know which method your business may be required to use, and to understand how this impacts on your day-to-day bookkeeping. Find out more with Mooncard.
What is accrual accounting?
Accrual accounting is the accounting method by which receipts (income) and expenses (outgoings) are recorded on the basis of the time they are accrued rather than when cash actually exchanges hands. It means that receipts and expenses are recorded according to the date of the invoice to or from the company rather than the date upon which the invoice is settled. It is contrasted to “cash” accounting, which records income and expenditure when money enters or exits the company’s accounts.
Accrual accounting records liabilities when these are incurred, even if they have not yet been paid for. Similarly, it records sales when the product or service is delivered, even if the client is not expected to pay for the item immediately and the revenue is expected at a later date. In more technical terms, accrual accounting records accounts “receivable” and accounts “payable”.
The advantages of accrual accounting
Although accrual accounting might initially appear to be more complex, and for many small- and medium-sized businesses this is in fact the case, accrual accounting does provide a more accurate picture of the financial health of a company.
This is largely due to the fact that accrual accounting also takes into account transactions that have been made but which remain to be settled.
As such, it provides a much more accurate, long-term picture of the company’s financial health.
Accrual accounting really comes into its own when a company incurs expenditure and payments straddling several accounting periods. For example, if a company sells a large amount of stock at the end of one financial period but does not expect to receive payment for it until into the next financial period, because payment is expected, it will be recorded in the first year. As such, companies have a much better handle on future inflows and outflows of cash and can make informed decisions on this basis.
Example of accrual accounting
If a company makes a large volume of sales to customers on the basis of a credit system, it will no longer have the stock available, but has not yet received payment for it. While a cash-based system would record sale on the date the money is received, accrual accounting records it on the day the transaction was made, i.e. the day the stock left the company.
Let’s look at an example of accrual accounting in practice. A company specialising in IT services delivers a website to a client on 15 February and issues its invoice on that day with a 30-day payment term. The end client ultimately settles the invoice on 15 March.
If the company was using the cash accounting system, the sale would appear in the company’s records on 15 March. VAT on the transaction would become payable on that date.
If the company was using the accrual accounting system, the sale would appear in the company’s records on 15 February, the day the product was delivered to the client. VAT is due based on the date of 15 February.
The challenges of accrual-based accounting
As we have seen, the cash accounting method is often the right choice for small- and medium-sized businesses due to its simplicity. However, it does have certain limitations, and for many companies, the advantages of using the accrual method far outweigh the more complicated processes it involves.
That said, there are challenges with implementing an accrual based system.
One of these challenges, and not the least of them, is that the method involves an extra layer of information which has to be added to the accounting process. It involves a change in the accounting process itself which, depending on the size of the company, may require input from an accountant.
Another potential challenge is that VAT is due to the government when the transaction takes place, not when the liability or credit is settled. Small businesses can often encounter cash-flow difficulties due to late payers, and the accrual-based system can compound these difficulties.
In the UK, businesses with a turnover of more than £150,000 are required to use the accrual method.
For most small- and medium-sized businesses with a turnover of less than £150,000, the cash-based accounting method may remain the easiest and most relevant method to use. However, when a more accurate picture of a company’s long-term financial health is required, it may be worth considering the accrual method. Mooncard provides managerial accounting solutions which can be adapted to the accrual-based method. It’s worth seeking expert advice to find out which method is best suited to your business. Either way, get in touch with Mooncard for a free demonstration of how our accounting solutions can make your life easier.