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What is the accruals concept?



Whilst cash-flow is one of the most important elements of managing a small business, the businesses accounts are often prepared using the accruals basis of accounting. In fact, the financial statements for a company are required to be prepared using the accruals basis rather than the cash basis. The fundamental difference between the accruals basis and the cash basis is that the accruals basis includes costs and revenues on the basis of the period to which they relate as opposed to the period in which the cash transaction actually took place. This may mean that if you maintain your records primarily by recording cash transactions then certain adjustments will be required for the preparation of formal business accounts or financial statements.

Worked Example - Cash vs Accrual Basis of Accounting

Your business pays the rent for its property 3 monthly in advance and has paid £3,000 on 1 January 2014 for the period 1 January to 31 March 2014. The cash basis of accounting will show a £3,000 payment in January and zero payment in February and March. Under the accruals basis of accounting, the P&L for each of the 3 months from January to March will show a £1,000 charge for rent on the basis of the amount of rent due for that period, regardless of when the rent was actually paid. Under the accruals basis, in this example, the rent paid in advance is treated as a prepayment. So the transactions during January will show a credit to cash of £3,000, a debit to profit and loss rent expense of £1,000 and a £2,000 debit to balance sheet prepayments.

Had the rent been paid in arrears on 31 March for the same period the cash basis of accounting would change to show a £3,000 payment in March as opposed to January. Under the accruals basis, the profit and loss account would remain the same. The difference, though, would be that in January and February an accrual would be made to record the £1,000 cost in the P&L - Debit P&L Rent Expense, Credit Balance Sheet Accruals. The accrual representing the amount owed by your business for rent at the end of each month.
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