Understanding Accruals in Accounting

At Towerstone Accountants we provide specialist small business accountancy services for owners, directors, and growing businesses across the UK. We created this webpage for small business owners and managers who want clear explanations of accounting terms, processes, and concepts they may encounter when running a business. Our aim is to make financial language easier to understand, and help you make better informed decisions with confidence.

The word accrual is one of the most common accounting terms people encounter, and also one of the least clearly understood. It appears in accounts, bookkeeping software, year end adjustments, and conversations with accountants, yet many business owners feel unsure what it actually means or why it matters. Some see accruals as a technical complication added at the end of the year. Others assume they are only relevant for large companies. In reality, accruals sit at the heart of how accurate financial reporting works, especially in the UK.

In my experience as a chartered accountant working with small businesses, sole traders, and limited companies, confusion around accruals often leads to misunderstandings about profit, tax, and cash flow. People look at their bank balance and assume that tells the full story. Accruals exist precisely because it does not.

In this article, I want to explain clearly what an accrual is, how it works in practice, why it is used, how it affects your accounts and tax, and when it matters most. This is written in plain UK English, grounded in real world accounting practice, and aimed at helping business owners understand what is really going on behind the numbers.

What an Accrual Actually Is

An accrual is an accounting adjustment used to record income or expenses in the period they relate to, rather than the period when cash is received or paid.

In simple terms, accruals make sure your accounts reflect what has actually been earned or incurred during a period, not just what has moved through the bank.

An accrual is typically used when:

• You have received goods or services but not yet paid for them

• You have earned income but not yet been paid

• Costs or income span across accounting periods

Accruals ensure that profits are calculated fairly and consistently.

Why Accruals Exist at All

If accounting was based purely on cash, results would swing wildly depending on timing of payments rather than business performance. One late bill or one early customer payment could distort profit dramatically.

Accruals exist to solve this problem.

They ensure that:

• Income is matched to the period it was earned

• Expenses are matched to the period they relate to

• Accounts reflect economic reality rather than cash timing

This principle is known as the matching principle, and it is fundamental to accrual accounting.

Accrual Accounting Versus Cash Accounting

To understand accruals properly, it helps to contrast accrual accounting with cash accounting.

Under cash accounting:

• Income is recorded when money is received

• Expenses are recorded when money is paid

Under accrual accounting:

• Income is recorded when it is earned

• Expenses are recorded when they are incurred

Accruals are the adjustments that make this possible.

Many small businesses start on a cash basis because it feels simpler, but most limited companies and many larger sole traders use accrual accounting because it gives a more accurate picture.

A Simple Example of an Accrual

Imagine you receive an electricity bill in January for electricity used in December.

If your year end is 31 December, that cost belongs to December, even though the bill arrives and is paid in January.

An accrual is created to record that December cost in the December accounts.

Without the accrual:

• December profit would be overstated

• January profit would be understated

The accrual corrects this timing issue.

Expense Accruals Explained

Most accruals in small businesses relate to expenses.

An expense accrual is used when you have incurred a cost but have not yet received the invoice or paid it by the end of the accounting period.

Common examples include:

• Utilities

• Rent

• Professional fees

• Subcontractor costs

• Interest

The accrual estimates the cost that relates to the period and includes it in the accounts.

Income Accruals Explained

Income accruals are used when income has been earned but not yet invoiced or received.

This often occurs in businesses where work is done before billing, or where billing is done periodically.

Examples include:

• Work completed but not yet invoiced

• Interest earned but not yet received

• Ongoing service contracts

Income accruals ensure revenue is recognised in the correct period.

How Accruals Appear in the Accounts

Accruals affect both the profit and loss account and the balance sheet.

When an expense accrual is recorded:

• The expense increases in the profit and loss account

• A liability appears on the balance sheet

When an income accrual is recorded:

• Income increases in the profit and loss account

• An asset appears on the balance sheet

This is why accruals are not just technical adjustments. They have real impact on reported profit.

Accruals and Profit

Accruals directly affect profit.

If expenses are accrued properly, profit reflects the true cost of running the business during that period.

If accruals are missed or incorrect:

• Profit may look higher than reality

• Tax may be overstated

• Decisions may be based on misleading figures

This is why accountants pay close attention to accruals at year end.

Accruals and Cash Flow

One of the most important things to understand is that accruals do not involve cash movement.

An accrual adjusts profit, not bank balance.

This is why businesses can appear profitable on paper but struggle with cash flow, or appear less profitable while having strong cash.

Accruals explain the difference between profit and cash.

Understanding this difference is key to running a sustainable business.

Accruals and Tax

In the UK, most limited companies calculate Corporation Tax based on accrual accounting.

This means:

• Tax is based on accrued profit

• Not on cash received or paid

If expenses are accrued, they reduce taxable profit in the correct period.

If income is accrued, it increases taxable profit even if cash has not yet arrived.

For sole traders, the position depends on whether cash basis or accrual basis is used. Many still use accruals, especially as income grows.

Why Accruals Matter at Year End

Accruals become particularly important at the end of an accounting period.

Year end accounts aim to present a fair view of the business at a specific point in time.

Accruals ensure that:

• All relevant income is included

• All relevant costs are recognised

• Profit is not artificially inflated or deflated

Without accruals, year end figures would be unreliable.

Common Accruals at Year End

Some accruals appear almost every year in many businesses.

These include:

• Electricity and gas

• Telephone and internet

• Accountancy fees

• Interest

• Payroll related costs

These costs recur regularly and often span across accounting periods.

Accruals Versus Prepayments

Accruals are often confused with prepayments.

They are related, but opposite.

An accrual records a cost incurred but not yet paid.

A prepayment records a cost paid in advance for a future period.

For example:

• An accrual covers unpaid past costs

• A prepayment covers paid future costs

Both adjustments ensure costs are matched to the correct period.

Why Accruals Confuse Business Owners

Accruals often confuse people because they feel abstract.

Common frustrations include:

• Profit changing without cash movement

• Tax being due on money not yet received

• Accounts not matching bank balance

These frustrations usually disappear once the purpose of accruals is understood.

Accruals are not designed to complicate matters. They are designed to show truth.

Accruals in Accounting Software

Modern accounting software handles accruals automatically to some extent, but not completely.

Recurring bills, payroll, and depreciation may be accrued automatically.

Other accruals require manual judgement.

This includes estimating costs or income where invoices have not yet been received.

Software does not replace understanding.

Judgement and Accruals

Accruals often involve judgement.

Estimating an electricity bill or professional fee requires experience and reasonableness.

This is why accruals are reviewed carefully by accountants.

The goal is not precision to the penny, but a fair and reasonable estimate.

When Accruals Are Too High or Too Low

Incorrect accruals can distort results.

If accruals are too high:

• Profit may be understated

• Tax may be deferred unnecessarily

If accruals are too low:

• Profit may be overstated

• Tax may be higher than it should be

This is why accruals are reversed and refreshed each period rather than left unchanged.

Reversing Accruals

Most accruals are reversed in the following accounting period.

This avoids double counting when the actual invoice is posted.

For example:

• An accrual is recorded at year end

• The accrual is reversed at the start of the new year

• The actual invoice is posted when received

This keeps accounts accurate over time.

Accruals and Management Accounts

Accruals are not just for year end.

Good management accounts include accruals so that monthly or quarterly results are meaningful.

Without accruals:

• Month to month comparisons become unreliable

• Decisions may be based on timing rather than performance

Accruals support better planning and forecasting.

Accruals in Small Businesses

Some small businesses avoid accruals because they feel unnecessary.

This is understandable early on, but as a business grows, accruals become more important.

They help answer questions like:

• Are we actually profitable

• Are costs under control

• Can we afford to grow

Cash alone cannot answer these questions.

Accruals and HMRC

HMRC expects accounts prepared on an accrual basis to include proper accruals.

Missing or inconsistent accruals can raise questions during enquiries.

This is particularly relevant for:

• Corporation Tax returns

• VAT reconciliations

• Loss claims

Accruals support credibility and compliance.

Common Mistakes With Accruals

Some of the most common mistakes include:

• Forgetting to accrue regular costs

• Leaving old accruals unreversed

• Accruing the same cost twice

• Guessing without evidence

• Confusing accruals with prepayments

These mistakes are usually administrative rather than intentional.

How an Accountant Uses Accruals

Accountants use accruals to bring clarity.

We look at:

• What relates to this period

• What does not

• What is missing

• What needs adjustment

Accruals are part of telling the full financial story.

Accruals and Business Decision Making

When accruals are used properly, business decisions improve.

You can:

• Trust profit figures

• Plan tax accurately

• Set prices more confidently

• Understand true margins

Without accruals, decisions are often reactive and cash driven.

Do Accruals Always Need to Be Perfect

No.

Accruals need to be reasonable and consistent, not perfect.

Accounting is about fairness, not exact prediction.

As long as accruals are based on sensible estimates and reviewed regularly, they serve their purpose.

When You Might Not Need Accruals

Very small businesses with minimal transactions may not need detailed accruals, especially if using the cash basis.

However, once transactions increase, or once you operate as a limited company, accruals quickly become essential.

Why Understanding Accruals Reduces Stress

Many business owners fear accruals because they do not understand them.

Once understood, accruals often bring relief.

They explain:

• Why profit and cash differ

• Why tax feels disconnected from the bank

• Why figures change at year end

Understanding replaces confusion with control.

Final Thoughts

An accrual is not a trick or a complication. It is a tool used to show the true performance of a business over time.

Accruals ensure income and expenses are recorded where they belong, not where cash happens to move. They support accurate profit, fair taxation, and better decision making.

If you see accruals in your accounts and feel unsure what they mean, that uncertainty is understandable, but it is also solvable. Once you grasp the principle, accruals stop being intimidating and start making sense.

Good accounting is not about chasing numbers. It is about understanding reality. Accruals are one of the most important ways accounting achieves that.

You may also find our guidance on management accounts and accounts receivable useful when exploring related accounting topics. For a wider collection of plain English explanations, you can visit our knowledge hub.