By Peggy Tee …©

Accrual accounting is a method of matching expenses with income, regardless of whether or not cash has been paid or received for these transactions. An accrual can be an accrued expense or revenue; for example a credit worthy customer who buys goods from you but pays three months later would be recognised as a debtor and revenue from the sale would be recognised at the point of transaction; under cash accounting no revenue would be recognised until the monies are received. Many small businesses start with cash accounting but eventually move to accrual accounting to facilitate the growth of the business.

Reflects the true profit or loss of the business

Many businesses operate on a monthly budget or reporting on a monthly basis. However not all bills are invoiced similarly. Utility bills are often billed quarterly. Accrual accounting takes these expenses into account regardless of when an invoice is received or paid. For example, under cash accounting a prepayment of rent for six months for the period of January-June would be recognised as an expense in the month that it was paid. This would result in an understatement of profit and a consequent overstatement of profit for the subsequent months. By contrast, accrual accounting allocates rent expense over the entire six month period, recognising costs and expenses as and when they are realised.

Reflects the true financial position of the business

Accruals take into account future expenses and revenue. Therefore accrual accounting is a fair representation of the business’s assets, liabilities and indirectly its future profitability. Cash accounting is simplistic and therefore is unable to capture the added complexity of deferred revenue or accrued expenses, both of which affect the financial position of businesses.

For example, inventory is recognised as an expense under cash accounting, regardless of if all stock has been sold by the end of the accounting period. Accrual accounting recognises cost of goods sold only on actual inventory sold; the remainder is recognised as an asset on the balance sheet. This way of accounting is a more accurate measure of the business’s financial performance.

Tax benefits

Accrual accounting allows expenses to be deducted for the tax year even if cash has not been paid for these items. Under accrual accounting, depreciation is also recognised as a deduction. Depreciation is a way of apportioning capital expenditure over the period of a non-current asset’s useful life. This effectively reduces the taxable income of businesses, which results in lower tax.

Credit and complexity

As businesses grow in size, cash based accounting is not longer sufficient. The survival of many businesses relies on credit and accrual accounting effectively records and measures credit — both owed and owing. Accrual accounting allows businesses to use credit lines, transact with third parties, offset inter-company transactions and transfer risk.