Accruals

Accruals vs cash basis accounting

There are two main bookkeeping options for businesses:

• Cash basis accounting: Cash accounting relies on real money flow to monitor business transactions. Payments are booked only when cash comes in or goes out of an account.

• Accrual basis accounting: This method considers all committed transactions as assets and liabilities to the company’s treasury, even if there has been no exchange of cash.

Because so much business operates on credit, and because invoices often have 30-90 day windows for payment, most standards consider the accrual basis of accounting to be more accurate.

Examples of accruals

As with most company transactions, we can separate these into accounts payable and accounts receivable. Payables include all expenses and costs that the company needs to pay. Receivables predominantly includes all the payments the company receives from customers.

Accrued payables examples

These are any obligatory payment that has not yet been executed, including:

• Payroll expenses such as salaries, bonuses, and vacation days

• Credit card or bank fees and interest

• Supplier invoices (rent, utilities, services)

• Tax payments if not already paid

• Audit and consultancy fees

In fact, most corporate transactions are committed ahead of time and paid later. Companies will book them against the relevant accounting period, even if the cash statement won’t be updated until later.

Accrued receivables examples

These are all the payments the company can reliably expect to receive:

• Invoices sent to customers for goods or services (to be paid in future)

• Tax refunds, grants, and awards

• Investment dividends and interest

Most direct-to-consumer brands will have a low number of receivables - they usually get paid before goods or services are delivered. But for large purchases, subscriptions, and corporate services, it’s common for payment to arrive weeks or months after the transaction takes place.

How to record accruals in financial statements

Accrued expenses and receivables impact several of your key journal entries. We’ll focus on expenses for this section, but of course receivables work much the same way (only as an asset rather than a liability).

Journal entries

Every company transaction requires a journal entry in the general ledger, and accruals are no different. Each accrual entry shows an asset or liability for the company in the form of committed payments.

There are two steps: booking the transaction as accounts payable or receivable in a given month, and then recording the actual payment received. The second step involves adjusting entries, where you update the previous transaction to show that it has been settled. You don’t actually change the previous period’s records, but rather create adjusting entries for all the payments received in the month or quarter you receive them.

Income statement

As the name suggests, the income statement shows your company’s income for a given accounting period, to give a clear picture of overall financial performance.

Accruals are recorded on the income statement in the period they are earned, which is often not when cash is received or sent.

This document is actually sometimes known as the “accrual income statement” for this reason.

Cash flow statement

Unlike the income statement, the cash flow statement focuses on cash actually moving in and out of the business. Therefore accruals aren’t reflected here - only the payments realized (both in and out of the business).

Balance sheet

Your balance sheet reflects your current liabilities and assets at any one time. Naturally, expense accruals must be recorded to accurately show your financial position.

Accountants should record each expense accrued during a given fiscal period - usually monthly or quarterly. Accrued accounts payable belong in the liabilities column, alongside taxes due, loans, and other liabilities.

The key difference between the income statement and balance sheet is that the latter shows the current situation when the sheet is produced, whereas the former shows changes over a month or quarter.

How accruals impact year-end financial reporting

The goal of end-of-year financial statements is to accurately show the company’s financial position. This is essential for financial reporting to shareholders and authorities, and also helps build worthwhile projections for the coming years.

If accruals were not included in your year-end reports, you might have a clear idea of actual cash flow, but not an accurate reflection of the current fiscal year. Because so much business isn’t done in real-time cash transactions, ignoring accruals means you really have no idea of your current liabilities. And naturally, liabilities may be of real concern if they’re significant enough.

For cash-intensive small businesses, accruals may not be a significant concern. But in most modern, fast-growing companies, the current cash in your accounts is likely less important than the accrued revenue and debts to be paid in the future.

How to manage accrued expenses easily

The biggest challenge in financial accounting is almost always having easy access to the data. If every financial transaction is accurately listed and easy to find, the finance team can close the books and move onto the following month easily.

The challenge is that most companies have disparate payment methods, and the finance team doesn’t always know what’s accrued in real time.

Invoices are a good example. Most often, the finance or purchasing team processes and pays invoices. But it’s the non-finance teams who find the suppliers, negotiate prices, and sign the agreement. It’s not until the invoice arrives with the finance team that they truly know what has been committed.

This is complicated where the work done was for a previous period. In theory, work billed in March should appear in the ledger for that month, even if the invoice isn’t paid until May. And the same goes for subscription credit card payments, which again may be handled by the IT team. The finance team has no idea until the payment is processed.

The single best way to resolve this issue is to centralize your payment methods. Avoid having one process for invoices, a completely separate one for expense claims, and a third for credit cards. All of these are expenses and serve roughly the same purpose.

This is where a spend management platform is so valuable. This puts all of your payment methods in one place, so Finance has a real-time overview of what’s spent. Good ones also let teams create purchase orders for approval in advance, so the finance team knows exactly what’s committed for the coming period.

The longer the delay before financial transactions reach the finance desk, the more backtracking and detective work you need to do. Conversely, an up-to-date purchasing process that gives you real-time visibility lets you book accruals and close the books in no time at all.