Understanding accruals is an important part of the budgeting process for Claire Whalley, co-founder and CEO of the Republico craft brewery brand.
“We use accounting software to show us what liabilities are accrued, and that means we can produce more accurate forecasts,” she says. “Accruals are important in understanding what cash flow is required to meet our business commitments.”
What is an accrual?
An accrual is money that a business has earned, or will need to spend, but money hasn’t yet changed hands.
For example, a business might be liable for tax for several months before the bill is paid, meaning this tax is an “accrued expense”. Meanwhile, an invoice to a customer that is owed but not due for payment for 28 days would be considered “accrued income”.
Without accrual accounting, companies would only be able to show income and expenses as the funds come in or out of bank accounts. This can lead to a less accurate view of a company’s financial position.
Alex Walsh, a fellow chartered accountant with Rayner Essex, says a good illustration of how accruals work is to imagine that you run a home renovations business and are completing a £10,000 project for a customer.
“You might invoice the customer £10,000 before you receive an invoice from a contractor for £2,000 of work,” says Walsh. “Your business looks like it has made £10,000 in profit, but you only really made £8,000.” In this example, accruals show what it owed to whom, and provide a more accurate view of the company’s trading position.
Accruals can have a significant impact on an SME’s cash flow, so it could help to use the American Express® Business Gold Card for business expenses that won’t be paid immediately. The Card gives you up to 54 days¹ until payment is due, meaning you have more flexibility on business spending.
Examples of accruals
Unpaid invoices
When you file an invoice but have yet to receive payment, this is a common accrued asset. On the other hand, invoices that you’ve been issued by customers, which you’ve yet to pay, would be considered accrued liabilities.
In the case of the Republico craft brewery brand, paying supplier invoices in a timely manner is important for cash flow, so the insights provided by accrual accounting can be vital. “When we order bottles and glass for our gin, [because] they’re custom made, we have to order in bulk,” says Whalley. “This means we might receive an invoice of more than £20,000”, not an unsubstantial sum, but accrual accounting means the company always has an accurate view of their financial position even when money has yet to change hands.
VAT
Companies are liable for VAT on each VAT-rated sale, but they may not pay the bill in the first instance or perhaps not for several months. Because of this, VAT is considered a common accrued liability.
Salary and wages
Other common examples of accruals are salaries and wages, which lots of businesses typically pay only after work has been completed. Also known as arrears, it's important for businesses to track owed wages so they have the cash available to pay employees at the appropriate time.
Advantages of accruals
Clearer insight into the financial position
The biggest advantage of accruals accounting is that it provides your business with a much better overview of your financial position than cash accounting.
“Let’s imagine a retailer has £500,000 in the bank and is considering investing in additional stock ahead of a seasonal sale,” says Walsh. “If the retailer is only considering bills that have been paid already, there is a risk they buy new stock but then immediately need to pay a VAT bill, or a large supplier invoice. The resulting cash flow shortage could seriously harm the business.”
Positive future data for potential investors
The flip side of accruals is that they can help to show your company’s future – which could be vital if you are applying for a new contract or investment.
The same retailer might be looking for a bank loan to fund a store expansion. On paper, his company might not qualify for the funding, but once pending payments from trade customers are taken into account, the resulting boost in revenue could help that company to secure the finance.
Creating better forecasting data
At Republico, perhaps the biggest advantage of accrual accounting is that it helps Whalley have long-term and accurate forecasting. Having forecasts for the year ahead allowed Whalley to spot a sales dip in November 2022, before it was reflected in the company’s bank account.
“I could see that we were fine for our next rent payment, but that things would potentially look tight for the payment after that,” she says. “Being able to see that four months ahead allowed us to take action to inject some extra revenue into the business, such as hosting wine-tasting evenings using stock we had already bought and using a quiz night to bring in new customers to our bar.”
Disadvantages of accruals
It can be more complicated
One of the key challenges of accrual accounting is that it can be more complicated to understand than basic cash accounting, which can be used by any business that turns over less than over less than £150,000. If your business used cash accounting when it was smaller, then the switch to accruals could present some challenges, says Walsh.
For this reason, Walsh advises most SMEs to start out using accruals accounting. The good news is that most online accounting services will automatically apply accruals accounting with a single click of a button, says Walsh.
It can be more time-intensive
Accruals rely upon having staff and knowledge to capture liabilities and assets at the point of purchase. This could mean having a dedicated accounts person who can track billing and expenses, on a weekly or monthly basis. It is important that accruals are up-to-date and accurate to benefit from this type of accounting method.
1. The maximum payment period on purchases is 54 calendar days and is obtained only if you spend on the first day of the new statement period and repay the balance in full on the due date. If you'd prefer a Card with no annual fee, rewards or other features, an alternative option is available – the Business Basic Card.
