What is accrual accounting?
Accrual accounting is a financial reporting method where you record income when it is earned and expenses when they are incurred, regardless of when cash moves in or out of your bank account. If you deliver work in March and the client pays in May, you recognise the revenue in March. If you receive utility services throughout December but pay the supplier invoice in January, you log the expense in December.
This approach underpins the accrual basis of accounting across business finance. Under UK company law, specifically The Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008, the statutory accruals principle mandates that all income and charges relating to a financial year must be taken into account without regard to the date of receipt or payment.
Under official GOV.UK guidance, limited companies cannot use the cash basis and must report using traditional accrual accounting. HMRC also requires that taxable trading profits for Corporation Tax derive from statutory accounts prepared under UK GAAP or UK-adopted IFRS on an accruals basis.
How accrual accounting works
The fundamental engine behind accrual accounting is the matching concept. This accounting convention requires businesses to report revenues alongside the direct costs incurred to generate that revenue within the same reporting period. Matching income and expenditure gives management, lenders, and investors a reliable picture of gross margin and operating performance across each month, quarter, or year.
In practical bookkeeping, accrual accounting connects the income statement directly to the balance sheet using double entry bookkeeping. When economic activity takes place before cash moves, you create balance sheet adjustments through a journal entry:
- If you earn revenue before receiving cash, you recognise income on the profit and loss account and establish an asset on the balance sheet, such as accrued income or accounts receivable.
- If you receive cash before delivering services, you hold the payment as a liability on the balance sheet (deferred revenue) and release it to the profit and loss account once the work is completed.
- If you pay for expenses upfront, you record an asset (prepaid expenses) and transfer the cost incrementally to profit and loss over the period benefited.
Accrual accounting vs cash basis accounting
The primary alternative to accrual accounting is cash basis accounting. Under the cash basis, transactions are recorded only when cash enters or leaves the business bank account. If an invoice is sent in November and settled in February, the cash basis registers zero revenue until February.
From 6 April 2024, HMRC established the cash basis as the default accounting method for unincorporated sole traders and partnerships by removing the £150,000 turnover entry cap and £300,000 exit threshold (GOV.UK, 2024). Unincorporated sole traders can still elect to use traditional accrual accounting on their Self Assessment tax return. In contrast, under official GOV.UK guidance, limited companies cannot use the cash basis and must prepare their accounts using traditional accrual accounting.
Key differences in financial reporting
The divergence between cash and accrual methods influences three key areas of financial reporting:
- Profitability versus cash position: Accrual accounting measures genuine trading profitability, whereas the cash basis reflects liquidity movements. A business may report strong operating profit on an accrual basis while experiencing cash shortages if clients delay payment. This divergence makes the cash flow statement an essential tool alongside accrual accounts to verify whether an entity can service its current debts.
- Working capital visibility: Accrual accounting reflects current obligations and receivables alongside cash positions. This visibility allows finance leaders to monitor working capital cycles and spot operational bottlenecks before they threaten solvency.
- Reporting consistency: Cash basis figures can fluctuate erratically based on arbitrary payment timing. If an enterprise pays two years of commercial rent in a single month, cash basis accounting shows an artificial plunge in profit, whereas accrual accounting spreads the expense evenly across the periods that occupy the property.
Common examples of accrual accounting
Finance teams routinely process adjustments across several transaction categories during the month-end close.
Accrued revenue and deferred revenue
Accrued revenue represents income earned for goods or services delivered during the period for which no sales invoice has yet been raised by the balance sheet date. For example, if a financial consultancy completes £8,000 worth of advisory hours in March but cannot issue its invoice until client sign-off in mid-April, accrual accounting requires an adjusting entry in March: debit accrued income (current asset) and credit revenue (profit and loss) for £8,000. In April, raising the sales invoice transfers the balance from accrued income into accounts receivable.
Deferred revenue, also referred to as deferred income or unearned revenue, represents payments received from customers before services are delivered. Consider a software company that receives £36,000 upfront in December for an annual software subscription covering January to December of the following year. Under accrual rules, the business cannot record £36,000 as December revenue because it has not yet delivered the service. Instead, it debits cash and credits deferred income (current liability) on the balance sheet. Throughout the following year, the company releases £3,000 each month from deferred income into monthly subscription revenue.
Accrued expenses and prepayments
Accrued expenses represent liabilities for goods or services received during an accounting period that have not yet been invoiced or paid before the reporting date. For instance, if a company consumes £1,200 of electricity in March but receives the utility bill in late April, the finance team debits utility expense on the profit and loss account for £1,200 and credits accruals on the balance sheet. When the bill arrives in April, the accrual is settled against accounts payable, ensuring March absorbs its genuine operating overhead.
Prepayments represent the opposite mechanism. If an organisation pays £12,000 upfront in January for an annual commercial insurance policy running from January to December, expensing the full £12,000 in January would distort the accounts. The finance team records an initial prepayment asset of £12,000, then debits £1,000 each month to insurance expense while crediting prepayments, spreading the cost evenly over the twelve months of coverage.
Advantages of the accrual method
Adopting accrual accounting delivers several operational and strategic advantages for growing organisations:
- Accurate long-term financial visibility: By recording transactions when they occur, accrual accounting reflects true underlying trading performance rather than temporary cash spikes or troughs.
- Informed commercial decision-making: Finance leaders can evaluate product margins, customer acquisition economics, and department budgets with realistic numbers that reflect true operational activity.
- Regulatory compliance: Under official GOV.UK guidance, limited companies cannot use the cash basis and must report using traditional accrual accounting.
- Investor and lender confidence: Banks, institutional investors, and venture capital funds rely on accrual-based financial statements to assess creditworthiness, calculate enterprise value, and verify sustainable growth.