Learn the basics of the accrual method of accounting with easy-to-understand examples and definitions.
What Is Accrual Accounting?
The reason for doing this is so that businesses can get an accurate forecast of their financial position, instead of relying only on cash account transactions.
Accrual accounting works with the matching principle, whereby expenses and revenue are recognized within the same period. Simply put, the revenue is recorded and when debt is taken on, the expenses are recorded.
This can help in predicting a company’s financial performance as it looks at the current and future cash flows.
Accrual accounting is used by most companies, except for very small businesses that may not benefit from this type of accounting. However, any company that carries inventory or uses credit sales must use accrual accounting, regardless of its size.
Benefits of Accrual Accounting
There are many benefits to using the accrual accounting method:
- Allows for better decision-making and management of resources.
- Provides an accurate depiction of a company’s financial position.
- Companies can get immediate feedback on what to expect from the ins and outs.
- Allows businesses to accurately assess debts and income.
How Accrual Accounting Differs from Cash Accounting
Moving onto cash basis accounting – this is when transactions are recognized when cash is exchanged. This means the transactions are only recorded when cash payments are made or money is received, otherwise, it isn’t on the books.
Some may say that the cash accounting method is more straightforward because it will reflect funds already there. This is true for some businesses. However, if a large company has significant time gaps between providing products/services and receiving payment, there will always be a minus with cash accounting without the appropriate debits and credits.
Whereas, if a company uses the double-entry accounting method with accrual accounting, the debits and credits always balance each other out.
For example, say you’re a building company and your company receives £1,000 in bricks from a manufacturer. The £1,000 would be recorded under debits (assets). The equal amount would be recorded under credits (accounts payable).
As you can see, the double-entry accrual method keeps track of what a business has going in and out. This is regardless of whether funds have been exchanged, like with cash accounting. This means there is no chance of the business spending money it doesn’t have because the journal columns need to balance each other out.
Which Accounting Model Should I Use in the UK?
Technically, if your company makes more than £150,000 a year, you are required to use the accrual accounting system for tax purposes.
HMRC requires businesses that earn £150,000 or more to use the accrual system when filing taxes. However, if the company’s VAT taxable is less than £1.35 million, then it can file the VAT accounts using the cash accounting model.
Are Accruals Debited or Credited?
An accrued expense is seen as received, but not yet paid. Generally, an accrued cost is debited under expenses. Businesses can also apply a credit under the accrued liabilities so that they balance each other out.
Why Is the Matching Principle Important in Accrual Accounting?
The matching principle is important because it ensures that accrued revenue and accrued expenses are accounted for in the same accounting period. This provides an accurate depiction of a business’s financial health.
Accrual accounting is a way for a business to gain a more comprehensive and accurate overview of its financial statements, by recording expenses and revenue when they’re earned, not when they’re incurred.
Accrual accounting can get complicated, depending on the size of a business. It’s best to hire an accountant to ensure your business is doing what is required to keep on top of taxes and finances.