What are accruals?

How do accruals work in practice?

The accounts for a year are meant to show what happened in that year. Suppliers do not always invoice on time, and some costs — electricity, the accountant's fee for the year-end, a bonus agreed but not yet paid — arrive after the period they relate to. An accrual puts the cost into the right year anyway.

In the books, an accrual is a journal: the expense is increased, and a liability called accruals is created on the balance sheet. When the real invoice arrives in the new year, the accrual is reversed so the cost is not counted twice.

The same logic works in reverse for income. Work done and not yet invoiced at the year end is accrued income, an asset. Most small businesses have far more accrued costs than accrued income, because they invoice promptly and their suppliers do not.

A worked example

A design studio has a 31 March year end. Its accountant will charge £1,200 for preparing those accounts, but the invoice will not arrive until June. The electricity used in March is billed in April at £180.

Both costs belong to the year ending 31 March, so both are accrued: £1,380 goes into expenses, and £1,380 sits under accruals on the balance sheet. Profit for the year is £1,380 lower than the bank alone would suggest, which is the true figure.

On 1 April the accrual is reversed. When the accountant's invoice and the electricity bill arrive, they are recorded as normal and the reversal cancels them out. Nothing is counted twice, and the new year starts clean.

How do accruals differ from prepayments?

They are mirror images. An accrual is a cost you have used but not yet been billed for. A prepayment is a cost you have paid for but not yet used — a year's insurance paid in January, of which nine months belong to the next accounting year.

Accruals increase this year's costs and create a liability. Prepayments reduce this year's costs and create an asset. Both exist to put the cost in the period it belongs to.