What is accrual accounting?
For all but the very simplest business, there can be many time differences between business activity and cash transactions. Any time there is change in what you owe are or owed, or you make use of a business asset that you own, business activities/events take place. Many of these don’t involve cash transactions at the same time.
When using cash accounting:
- When payments are made, then record transactions
- Keep an informal record of invoices that are outstanding. These invoices are only recorded when cash payments are made
- Record large business assets when you pay for them. No changes are then made to these asset records until you sell or dispose of the asset. This could be many years later
Cash accounting example
Think of our service business with the customer paying on account. Now imagine that the customer is a bad payer. They take 3 months to pay their bill. In cash accounting, income is only recorded when the customer finally pays. In contrast, accrual accounting has income recorded when the work is done. Your bookkeeper records a second transaction when cash payment occurs. The time between these Customer bills that are outstanding are recognized as trade debtors. A trade debtor is a receivable (i.e. you are owed money)
- For our service small business example, it is of little value to make accounting records for services performed on a day by day basis. Instead, record services on a client and job basis. Jobs might be broken up into a week by week or month by month basis if they are long standing. The basis for breaking it up will depend on the contractual agreement you have with your client. You may provide that work is billed monthly or fortnightly for instance.
Cash accounting does not properly recognize monies that the business owes or is owed. These items, found on the balance sheet, are critical in understanding the financial position of your business. Changes to your assets or liabilities can be critically important to understand if your business is profitable. Cash accounting does not capture this information, thus leaving you in the dark. This information can be so important that without it, a profit and loss statement is essentially useless.
Accrual accounting transactions
An effective way to understand accrual accounting is to consider how it deals with various types of transactions. We will consider various types in turn.
Sales revenues and other income
The primary source of revenue for most businesses is sales. A sale could be the supply of a product to a customer. This could be the provision of a service to a customer. It can be mix of goods and services. It can occur at a point in time or over a period of time. A sale is generally considered to have occurred once a product is supplied or a service has been provisioned. Your business can then issue a sales invoice. Any invoice like documents issued before this time are really sales orders. They then become sales invoices when the supply or provision of the product/service has occurred.
It is quite possible to receive payment for a sale before the sale itself occurs – a payment in advance. The time of the payment is not directly relevant to the time of the sale.
Recording sales revenue
The revenue from the sale is recorded at the time of the sale:
- If your customer has already paid you, initially, their payment is recorded in an unearned income account (a business liability). At the time of the sale, their prepayment is discharged as you have now supplied the product or provided the service. More information about unearned income can be found below
- If you are making a cash sale, the payment to bank is recorded as sales revenue
- If your customer is to pay you in the future, your sales revenue will be recorded as a trade debtor (receivable).
Learn how to get paid faster when you invoice here.
Businesses also receive other types of income. They could be sales of long term business assets, donations for not-for-profits. Some of these types of income need to be recorded at various times based on specific criteria. This can get technical and is beyond the scope of this introduction article.
Purchasing is part of business life. Purchases may include web hosting, professional services and rent and outgoings for office premises. It also includes larger capital items such as cars, laptops, etc. These can be either outright purchases or through leases. Purchases also include any products purchased with intent to resale.
Like sales, purchases are recorded at the time the products are received or services consumed. Contrast this with cash accounting where purchases are recorded when payment is made.
- If you pay your supplier after making the purchase, then you are purchasing on account. You will have a trade creditor (your supplier). This debt is discharged when you pay them.
- Simple cash purchases are recorded at the time of purchase, which is also the time of payment.
- If you pay your supplier in advance, this payment is recorded in a prepayment account (a business asset). Once you receive the products or consume the service, this prepayment has become “used”. See below for more detail about prepaid expenses.
You can find a more detailed article about purchases here.
Monies paid for costs in advance are prepayments. Common examples include insurance premiums, lease payments, loan interest, annual subscriptions and memberships. The prepayment is the portion of money paid for services that have not happened yet. For interest prepayments, the interest relates to a future period. In most of these examples, the prepayment is consumed through the year. For example, if you have public liability insurance paid in advance for 12 months. The premium was $2,400. At the end of your financial year there is 5 months of the policy period remaining. You would show an expense in the year for $1,400 (7 months worth of premium or 2,400 times 7/12), and a prepayment of $1,000 (5 months worth of premium or 2,400 times 5/12). The $1,000 prepayment represents the 5 months of insurance that has not been “used” or “consumed”.
Prepayments are shown on your balance sheet as assets. This is regardless of whether the prepayment is refundable.
Prepayment concessional treatments may be available to you. In the United States, some taxpayers can elect to use the “cash method” and this allows prepayments to be immediately deducted for up to 12 months. Similarly, in Australia, many prepayments for services up to 12 months in advance can be deducted in the year paid.
Most tax laws only allow upfront deducting of certain prepayments for eligible small businesses. Generally, large businesses are only permitted to deductions in the year where the service is performed.
Even where you are eligible for upfront deductions of prepayments, it is still preferable to show prepayments as assets in your accounts. It shows that you are consuming services that you have paid for, even though no money is being physically spent in the remainder of the service period.
Unearned is like the prepaid expenses, but from the perspective of the supplier of the service. If you rent out office premises that you own on a lease and you receive advance payment, this is unearned income. It will become rental revenue proportionally through the lease period.
Unearned income is shown on your balance sheet as a liability. This liability “converts” into revenue during the service period. Once the period is complete, the liability is extinguished and all of the unearned income is now revenue.
Business owners should take careful note of unearned income. It highlights that your business is obligated to provide service, however no further payment will be received for these services. You should be aware of any cash flow implications of this.
Accrued income captures income that you have become contractually entitled to, but you haven’t invoiced for yet. This entitlement is a benefit to your business. This should be shown in your accounts as the benefit is of economic value. The revenue is shown in a revenue account and the accrued income shown in an asset account. Once you issue the invoice, the associated accrued income is no longer shown. You will show a trade debtor instead.
Accrued income captures expenses that you are contractually required to pay, but you haven’t received an invoice for yet. Your contractual obligations are more important than the fact you are yet to receive an invoice. These obligations need to be shown in your accounts in order to provide a true financial picture of your business.
Accrual accounting gives a better view of your business’ finances. This is because all of the economic activity of your business is shown as it occurs. A key benefit is being able to understand debts and obligations of your business. Contrast this with cash accounting where only payments are shown.
Accrual accounting captures timing differences between activity and payments. This includes sales, purchases and longer term arrangements such as prepayments and accrued income and expenses.
You may have to spend more time bookkeeping, but you gain a better understanding of your business. This enables you to make better decisions about your business.