Accruals in Plain Words
Educational only. This is not financial or tax advice. If you are unsure how your own business should keep its accounts, ask a qualified accountant.
In Level 1 you saw that a business can make a profit and still run out of cash. This level explains one of the main reasons: profit and cash are recorded at different times.
1. The Accruals Basis: The Core Rule
Under the accruals basis, you record a sale or a cost in the month it is earned or incurred. The date the money moves does not decide it.
- Earned means you have done the work or handed over the goods.
- Incurred means you have used the goods or service, or you now owe for it.
Compare this with the cash basis, which records money only when it lands in or leaves the bank.
An everyday comparison: you eat at a restaurant on Friday and pay the bill on Monday. The meal (the cost) happened on Friday and the payment (the cash) happened on Monday. The accruals basis puts the cost on Friday.
UK context:
- UK limited companies must prepare their accounts on the accruals basis.
- Since 6 April 2024, the cash basis is the default way that sole traders and partnerships without corporate partners work out taxable profit. They can choose (elect) to use accruals instead.
- Even if you file on the cash basis, the accruals view shows you whether the business is truly profitable. Rules differ in other countries.
2. Four Terms You Need
| UK term | US term | Plain meaning |
|---|---|---|
| Debtors | Accounts receivable | Customers who owe you money for work you have already done |
| Creditors | Accounts payable | Suppliers you owe money to for goods or services you have already received |
| Accruals | Accrued expenses | Costs you have used up but have not been billed for or paid yet (for example, this month's electricity, billed next month) |
| Prepayments | Prepaid expenses | Costs you have paid in advance for a future period (for example, next month's van hire, paid this month) |
A quick test:
- Debtors and prepayments: the cash comes in later than the profit, or goes out earlier than the cost. Both hurt cash first.
- Creditors and accruals: the cash goes out later than the cost. Both help cash for a while.
3. How to Classify a Transaction
For each transaction, follow these steps:
- Ask what happened. Is it a sale (income) or a cost?
- Find the profit month. When was the work done, the goods delivered, or the service used?
- Find the cash month. When did the money actually arrive in the bank or leave it?
- Compare the two. If they differ, you have a timing gap. Name it: debtor, creditor, accrual or prepayment.
Example: Hollow Oak Catering serves a lunch on 20 January and invoices £2,000 on 30-day terms. The customer pays on 25 February.
- Profit month: January, because the work was done then.
- Cash month: February.
- Through January and most of February, the customer is a debtor for £2,000.
4. Spreadsheet Task: Profit Month vs Cash Month
DO: Open a new spreadsheet and set up these columns:
- A: No.
- B: Description
- C: Amount (sales positive, costs negative)
- D: Profit month
- E: Cash month
Enter these 10 Hollow Oak Catering transactions. The full period runs from January to April.
| No. | Description | Amount (£) | Profit month | Cash month |
|---|---|---|---|---|
| 1 | Lunch catered 20 Jan, paid 25 Feb | 2,000 | Jan | Feb |
| 2 | Food bought 5 Jan on 30-day credit, paid 4 Feb | -600 | Jan | Feb |
| 3 | Van hire for March, paid in advance 20 Feb | -300 | Mar | Feb |
| 4 | Deposit received 15 Feb for wedding catered 10 Mar | 500 | Mar | Feb |
| 5 | Wedding balance, paid 31 Mar | 1,000 | Mar | Mar |
| 6 | March staff wages, paid 31 Mar | -800 | Mar | Mar |
| 7 | March electricity, billed and paid 10 Apr | -90 | Mar | Apr |
| 8 | Office party catered 28 Mar, paid 20 Apr | 1,200 | Mar | Apr |
| 9 | February kitchen rent, paid 1 Feb | -500 | Feb | Feb |
| 10 | Food bought 10 Mar on credit, paid 9 Apr | -450 | Mar | Apr |
DO: Build a summary table below the transactions, with Jan, Feb, Mar and Apr across the top in cells H2 to K2.
- In the Profit row, enter
=SUMIF($D$2:$D$11,H$2,$C$2:$C$11)and copy it across. - In the Cash row, enter
=SUMIF($E$2:$E$11,H$2,$C$2:$C$11)and copy it across. - Add a Total column to each row with
=SUM(...).
5. Check Your Work
You should get:
| Jan | Feb | Mar | Apr | Total | |
|---|---|---|---|---|---|
| Profit | 1,400 | -500 | 1,060 | 0 | 1,960 |
| Cash | 0 | 1,100 | 200 | 660 | 1,960 |
Then run these checks:
- Do the totals match? Both rows must equal
=SUM(C2:C11), which is £1,960. If they do not, a month label is mistyped. Look for "Jan " with a stray space, or "January". - Read the gap. January shows £1,400 profit but £0 cash. This is the Level 1 problem in miniature.
- Bonus check at the end of March. Cumulative profit is £1,960 and cumulative cash is £1,300. The gap is explained as follows: the office party debtor (£1,200) has not paid yet, while the March food creditor (£450) and the electricity accrual (£90) have not been paid either. Working it through: 1,960 − 1,200 + 450 + 90 = 1,300.
The totals match only because every item is settled by April. In real life, some items are always outstanding, so profit and cash rarely agree at any single date.
Key Takeaways
- The accruals basis records income when it is earned and costs when they are incurred, whatever date the cash moves.
- Debtors (US: accounts receivable) and prepayments mean cash is worse than profit for a while. Creditors (US: accounts payable) and accruals mean cash is better than profit for a while.
- Over a full period in which everything is settled, total profit equals total cash. Month by month, the two can be very different.
- UK limited companies must use accruals. Most sole traders and partnerships default to the cash basis for tax. Ask an accountant which applies to you.