What is Accrual Accounting?

Accrual accounting is the method of recording financial transactions when they occur rather than when cash is received or paid. Under this approach, revenue is recognised when it is earned and expenses when they are incurred, regardless of the timing of the actual cash flow. This principle is fundamental to producing financial statements that give a true and fair view of a business’s performance and position.

Section 1: The Core Concept

Under accrual accounting, the timing of a transaction’s economic effect determines when it appears in the books, not the timing of the cash movement.

1.1 Revenue Recognition

Revenue is recorded when the business has fulfilled its performance obligation, typically when goods are delivered or services are rendered. A UK consultancy firm that completes a project in March but does not receive payment until April records the revenue in March.

For a detailed look at how revenue is recognised under UK standards, see our article on revenue recognition .

1.2 Expense Recognition

Expenses are recorded in the period to which they relate, not when they are paid. If a company receives an electricity bill in January for December’s usage, the expense belongs in December’s accounts. This is closely related to the matching principle , which requires expenses to be matched against the revenue they help generate.

Section 2: Legal Requirements in the UK

2.1 Companies Act 2006

The Companies Act 2006 requires all UK limited companies to prepare their financial statements on an accrual basis. Section 395 states that individual accounts must comply with applicable accounting standards, and both FRS 102 (the Financial Reporting Standard applicable in the UK and Republic of Ireland) and IFRS mandate accrual accounting.

The only significant exception is for eligible small businesses that may choose the cash basis for income tax purposes. Even then, this option is limited to unincorporated businesses below a certain turnover threshold.

2.2 FRS 102 Requirements

FRS 102 Section 2 sets out the concepts and pervasive principles underlying financial statements, including the accrual basis of accounting. It states that an entity shall prepare its financial statements using the accrual basis except for the statement of cash flows.

2.3 HMRC and Corporation Tax

For corporation tax, companies must calculate their taxable profit on an accrual basis. HMRC expects businesses to follow generally accepted accounting practice (GAAP), which means accrual accounting for all limited companies.

Section 3: Accruals and Prepayments

Two key adjustments are central to accrual accounting:

3.1 Accruals

An accrual is an expense that has been incurred but not yet invoiced or paid. At the end of an accounting period, the business estimates the amount and records it as a liability on the balance sheet .

Example	Treatment
Staff wages earned but not yet paid	Debit: Wages expense / Credit: Accrued wages
Electricity used in December, billed in January	Debit: Utility expense / Credit: Accrued expenses
Interest accrued on a loan	Debit: Interest expense / Credit: Accrued interest

3.2 Prepayments

A prepayment is a payment made in advance for goods or services not yet received. The payment is recorded as an asset on the balance sheet and released to the income statement as the benefit is consumed.

Example	Treatment
Insurance paid annually in advance	Debit: Prepaid insurance (asset) / Credit: Bank
Rent paid three months ahead	Debit: Prepaid rent (asset) / Credit: Bank
Software licence paid for a full year	Debit: Prepaid software (asset) / Credit: Bank

At the end of each month, the relevant portion is transferred from the prepayment asset to the expense account.

Section 4: Accrual Accounting vs Cash Basis

Feature	Accrual accounting	Cash basis
Revenue recorded	When earned	When received
Expenses recorded	When incurred	When paid
Required for limited companies	Yes	No
Complexity	Higher	Lower
Gives true and fair view	Yes	Limited
Produces balance sheet	Yes	Not required
HMRC corporation tax	Required	Not applicable

The cash basis is simpler but does not show the full financial picture. Most UK businesses above a modest size are required or choose to use accrual accounting.

Section 5: How Accrual Accounting Affects Financial Statements

5.1 Income Statement

The income statement under accrual accounting shows revenue actually earned and expenses actually incurred during the period, regardless of cash flow. This provides a more accurate picture of profitability than the cash basis.

A company might show a healthy profit on the income statement while simultaneously having low cash in the bank, because customers have not yet paid their invoices.

5.2 Balance Sheet

Accruals create liabilities (amounts owed but not yet paid), while prepayments create assets (amounts paid but not yet consumed). These entries ensure the balance sheet reflects all known obligations and resources at the reporting date.

5.3 Cash Flow Statement

Because accrual accounting separates profit from cash, the cash flow statement becomes essential. It reconciles the profit figure back to actual cash movements, making clear how much cash the business has generated or consumed.

Section 6: Practical Application

6.1 Monthly Close Process

Businesses using accrual accounting typically perform a monthly close to ensure accounts are up to date:

Review all outstanding purchase invoices and accrue any missing expenses
Release the relevant portion of prepayments to the income statement
Recognise revenue for completed work, even if not yet invoiced
Record depreciation and amortisation for the month
Prepare and review the trial balance

6.2 Year-End Adjustments

At the financial year end, particular care is needed:

Cut-off testing ensures revenue and expenses are recorded in the correct period
Provisions are made for known liabilities where the exact amount is uncertain
Bad debt provisions adjust trade receivables to reflect expected credit losses
Stock adjustments ensure inventory is stated at the lower of cost and net realisable value

6.3 Impact on Tax

Accrual accounting can create timing differences between accounting profit and taxable profit. For example, a provision for doubtful debts reduces accounting profit but may not be deductible for corporation tax until the debt is actually written off. These differences are managed through deferred tax calculations.

Section 7: Advantages and Limitations

7.1 Advantages

Accuracy: Financial statements reflect economic reality, not just cash movements
Comparability: Businesses can be compared on a like-for-like basis because transactions are recorded consistently
Better decision-making: Management can see the true cost of operations and revenue trends
Stakeholder confidence: Lenders, investors and auditors rely on accrual-based accounts
Compliance: Meets the requirements of the Companies Act 2006 and UK GAAP

7.2 Limitations

Complexity: Requires more accounting knowledge and effort than the cash basis
Judgement: Estimates are involved in accruals, provisions and depreciation , introducing subjectivity
Cash flow risk: A profitable business can still run out of cash if receivables are not collected promptly
Cost: More time-consuming to maintain, potentially requiring professional accounting support

Section 8: Accrual Accounting and UK Accounting Standards

The accrual concept underpins several other important accounting principles:

The matching principle requires expenses to be matched to related revenue in the same period
Going concern assumes the business will continue, making accruals meaningful
Materiality determines the threshold above which accrual adjustments must be made
Revenue recognition provides detailed guidance on when revenue should be recorded under accrual accounting

Understanding accrual accounting is essential for anyone working with UK financial statements, whether preparing accounts, analysing financial ratios or conducting an audit .