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:
- Record transactions when payments are made
- Keep an informal record of invoices that are outstanding. Record invoices only when cash payments are made
- Record large business assets when you pay for them. These assets are then valued at this cost, potentially for many years. No changes made until you sell or dispose of the asset. This could be many years later
An accrual accounting system identifies your customers that have outstanding bills as trade debtors. The amount outstanding from a trade debtor is a receivable (i.e. you are owed money)
- For our computer service 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 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 happens when a product or service has been provided. Your business can then issue a sales invoice. Invoice-like documents issued before this time are only 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
Record revenue from sales when the sale occurs:
- Customers may prepay in advance of the sale. In this case, an unearned income account records this payment. Unearned income accounts are not revenue accounts, rather they are liability accounts. This is because you owe them future performance of the service or supply of goods. 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. This could include sales of long term business assets, or donations received by 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). When you pay your supplier, then this debt will be discharged.
- Record simple cash purchases at the time of purchase. This is also the time of payment.
- Use a prepayment account to record advance payments to suppliers. This prepayment is an asset of your business. 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 of prepayments 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.
Typically, prepayments are consumed through the year. For example, take a public liability insurance paid in advance for 12 months. 7 months of the insured period is for the current year. The balance of 5 months is for the next year. The insurance premium was $2,400. At the end of the 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 show as assets on your balance sheet. 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 shows as a liability on your balance sheet. 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 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.