Accrual accounting is preparing the business accounts using the accrual accounting concept, which is one of the fundamental accounting principles. The objective behind accrual accounting is ‘matching’, which is basically ensuring that all revenues and all expenditures are recorded in the accounting period to which they relate, i.e. to the accounting period in which the revenue was earned or the expense incurred. It doesn’t matter if the revenue wasn’t actually received in the accounting period, nor does it matter if the expense wasn’t actually paid in the accounting period, the important thing is to ensure the transaction is completely and accurately recorded.
Accrued expenses and prepayments are the most common accounting adjustments to make sure the accounts adhere to accrual accounting requirements, and these adjustments are best explained by way of an example.
Let’s suppose a business has a December accounting period end. In the March after the accounting period end the business receives a water bill for $300, which covers December, January and February. Since part of the water bill relates to our period end the accrual accounting principles state we need to include a proportion of the water bill in our accounts. If we do not have a precise amount the only way we can quantify the expense is to equally apportion it, therefore in this scenario we will include a $100 accrued expense ($300 x 1/3) by debiting the water rates account in the profit and loss account and crediting the accruals account in the balance sheet. There are many different types of expenses that will straddle two accounting periods, all of which are treated in this way under the accrual accounting principles.
In addition to expenses that straddle two accounting periods it is not uncommon to receive supplier purchase invoices late. You may make many purchases during the period to the end of December, i.e. before the end of the accounting period, but the supplier may not actually issue the invoice until after the accounting period end. Even though the invoices are received and settled after the end of the accounting period the expense still relates to the accounting period end and under the accrual accounting principles the expense needs to be recorded in our accounting period end.
In another example we will assume the same December accounting period end, as above. The business rents out a property for $12,000 per annum, which is paid quarterly in advance in February, May, August and November. The payment in November covers November, December and January, which is after our accounting period end. To record the entire $3,000 payment would not be in accordance with accrual accounting principles since the expense for January relates to the next accounting period. In this scenario we have a prepayment (i.e. a payment in advance) and, under the accrual accounting principles, we need to recognise this fact. The amount of the prepayment is $1,000 ($3,000 x 1/3) and is posted to the general ledger by debiting the prepayments account on the balance sheet and crediting the rent expense in the profit and loss account.
Under the accrual accounting concepts there may be other types of ‘matching’ adjustments such as providing for deferred and accrued income. Deferred income is income relating to the next accounting period but is received in the current accounting period, i.e. the customer pays in advance or upfront. Under the accrual accounting principles we need to debit the income account in the profit and loss account and credit the deferred income account in the balance sheet.
Accrued income is income that relates to the current period that is not received until the following accounting period. Under the accrual accounting principles we have to adjust for this by debiting the accrued income account in the balance sheet and crediting the sales account in the profit and loss account.
Once the current accounting period has been finalised and the general ledger accounts closed down, the accrual accounting concept requires us to reverse the adjustments, hence matching them to the correct accounting period.
All sets of accounts and financial statements are required to be prepared using the accrual accounting concept. It doesn’t matter whether the accounts are for a sole trade, a partnership, a limited liability partnership, a limited liability company or a public company all statutory and published accounts have to be prepared using accrual accounting.
Accounts that are produced for internal purposes, such as for management reporting, do not have to be prepared using accrual accounting but in the real world even internal management accounts that are only going to be used by the business owners are prepared using accrual accounting principles. Accrual accounting is the standardised and accepted method and that is what all organisations use.
Many people find the accrual accounting concept difficult to grasp at first, but if you take a step back and think about it accrual accounting is logical and it will soon fall in to place. Preparing accounts and financial statements using the accrual accounting concepts is not difficult, however it will require a bit of thought.
In the real world it is the accruals accounting concept that prevents accounts and financial statements being prepared the day after the end of the accounting period. Before the accounting period ledgers can be closed and the accounts prepared you need to ensure that all invoices relating to the period end have been received. Many suppliers take two to three weeks to issue purchase invoices, so if the business acquired goods and services close to the year end the purchase invoice won’t be received until the middle to the end of January, therefore the ledgers cannot be closed down until the end of the first month immediately after the accounting period end.