‘Remember that credit is money.’
Benjamin Franklin, American statesman, diplomat, writer, scientist and inventor
In a nutshell
Cash is not the same as profit.
Company accounts are prepared on the ‘accruals’ or ‘matching’ basis. This principle acknowledges the timing differences inherent in, and arising from, business transactions.
Sales and expenses should be ‘matched’ to the period when a transaction takes place, whether or not cash has changed hands.
Put simply:
- –sales are recognised when they are ‘earned’, as opposed to when cash is received
- –expenses are recognised when they are ‘incurred’, as opposed to when cash is paid.
Accruals accounting helps a business to identify its actual profit and net worth.
Need to know 
Sales and purchases
Business-to-business transactions are typically made on credit, i.e. a customer pays a supplier after an agreed number of days.
The time of the transaction is typically the point when goods are delivered or a service is performed, depending on the nature of the business.
The key concepts to understand are ‘earned’ revenue and ‘incurred’ expenses, as outlined in the following table:
| Earned revenue | Incurred expenses |
|---|---|
| Sales revenue is recognised in financial accounts, when it is ‘earned’, which may not be the same time as when cash is ‘received’ from a customer. | Expenses are recognised in financial accounts, when they are ‘incurred’ which may not be the same time as when cash is ‘paid’ to a supplier. |
| For example, a credit sale is recognised when it is made, before cash is received from a customer, which could be 30 or more days later. | For example, a credit purchase is recognised when it is made, before cash is paid to a supplier. |
The figure above illustrates that the timing of cash receipts and payments may be different to the timing of when sales and purchases are recognised in company accounts.
Why is this important? 
Accruals accounting is required by company law and is Generally Accepted Accounting Practice (GAAP) (see Chapter 19 Accounting and financial reporting standards).
Preparing financial accounts on an ‘accruals basis’ gives a more accurate reflection of a business’s current financial position and its net worth. Just because a business has sizable cash in its year-end balance sheet, it doesn’t mean that it is in a strong financial position. There may be a number of cash commitments immediately after the year end.
Illustration
Credit Ltd is a company that buys and sells products on credit from customers and suppliers. During the year ended 31 December 2021 it made the following transactions:
| Transaction | Amount | Transaction date | Settlement date |
| Purchases | £6,000 | 01 December 2021 | Cash paid 01 February 2022 |
| Sales | £10,000 | 15 December 2021 | Cash received 15 February 2022 |
If the above transactions were recorded using cash accounting, the profit earned by the business for 2021 would be shown as below.
| 2021 £ | |
| Sales | 0 |
| Purchases | 0 |
| Profit | 0 |
Therefore, a cash-based profit and loss account would give the impression that the business had not undertaken any trading activity during the year. However, it is clear that the business has bought and sold products during the year. Using accruals accounting, we can reflect the reality of what has happened, as follows:
| 2021 £ | |
| Sales | 10,000 |
| Purchases | (6,000) |
| Profit | 4,000 |
Company law and accounting standards require companies to reflect the substance, i.e. reality, of what has happened. The timing of cash receipts and payments is simply a settlement arrangement made between contracting parties that cannot alter the substance of the transaction.
When is this important? 
Accruals accounting is particularly important at a company’s financial year end, when financial accounts are prepared. A company’s accounts should capture all sales transactions within the year, irrespective of whether the cash relating to all sales has been received. Similarly, the accounts should reflect all purchase transactions within the year, whether or not cash has been paid.
If a business prepares regular management accounts (see Chapter 31 Management accounts), it is also important to account for any timing differences at each period end.
Examples of the accruals concept in practice
- ■Revenue recognition (see Chapter 6 Revenue recognition)
- ■Depreciation (see Chapter 9 Tangible fixed assets and depreciation)
- ■Debtors and creditors (see Chapter 12 Debtors and creditors)
- ■Prepayments and accruals (see Chapter 13 Prepayments and accruals)
- ■Provisions (see Chapter 14 Provisions and contingencies)
Auditors (see Chapter 20 External financial audit) will always be attentive to transactions around the year end to make sure they are reflected in the correct period. Large credit sales and credit purchases either side of the year end will have a clear impact on each year’s profit and therefore must be allocated to the correct year.
Nice to know 
‘Grey areas’
For most businesses involving simple products or services, establishing the point of the transaction is relatively straightforward.
However, for more complex situations, there are some grey areas which will require more thought and the input of accountants and/or auditors. Although there are a number of established methods, depending upon the transaction there may be some discretion over which method a company chooses as its accounting policy.
Here are a couple of examples of grey areas:
Example 1: Product and service combinations
There can be grey areas where products and services are combined, for example a product which includes after-sales service. The service could be performed some months following the delivery of the product and payment for the product. The company will need to establish a revenue recognition policy to determine the period(s) in which the sale proceeds and service expense should be allocated.
Example 2: Long-term projects
Construction companies with projects lasting several years need to have a clear revenue recognition policy. The stage of completion may not clearly reflect when the pre-agreed stage cash payments are received. This becomes even more complex when retentions (cash withheld until satisfactory completion) are involved.
See Chapter 6 Revenue recognition for more detail.
Optional detail 
The term ‘accrual’ often confuses non-accountants. The term is applied in a number of ways, for example in ‘accruals accounting (this chapter) and also in the context of accrued expenses (see Chapter 13 Prepayments and accruals).
Many of the words in accounting are derived from Latin, given that bookkeeping is credited to the Italian, Luca Pacioli. The Latin derivative of accrual is accrescere – which means to grow – and most dictionary definitions of accrual refer to accumulation. Unfortunately, this definition is still challenging to relate to the concept of accruals accounting, hence the simpler-phrased concept of ‘matching’.
Reflect and embed your understanding 
- 1Reflect on why the accruals concept must be used to reflect true performance by considering your personal income and expenditure for the last month. If you earned a salary but it was not paid to you by the month end, have you still ‘earned it’? Consider also the expenditure on your credit card for the same month? While you will not have to pay off the balance for around 28 days after the statement date, consider whether you have nevertheless incurred the expenditure at the time of the transaction? Your ‘profit’ for the month is the difference between what you earned and what you incurred, irrespective of whether the transactions were settled in cash.
- 2Compare accruals accounting and cash accounting to understand why accruals accounting prevents a business from manipulating its financial results by changing the terms of trade with customers and suppliers.
For an example organisation:
- 3Can it be clearly identified when a transaction has taken place? Is this supported by documentation?
- 4How does the organisation record its purchases and the associated goods/services received? At what point is a purchase recognised?
- 5Does the organisation prepare its management accounts using accruals accounting?
- 6Does the business offer credit to customers and receive credit from suppliers? If so, how is this process managed and recorded?
- 7Is there a clear understanding of accruals accounting and the impact of the timing of transactions?
For the authors’ reflections on these questions please go to financebook.co.uk
Where to spot in company accounts 
All company accounts will be prepared under accruals accounting as this is required by company law and is GAAP (see Chapter 19 Accounting and financial reporting standards).
When reviewing a set of financial accounts, it is important to be aware that cash is not the same as profit. There are most likely timing differences between when transactions are recognised and when the associated cash settlement takes place. Understanding the difference between profit and cash is one of the reasons why companies have to prepare a Cash Flow Statement (see also Chapter 5 Cash flow statement) in addition to a Profit and Loss Account (see Chapter 3 Profit and loss) as part of their financial accounts.
Consolidate and apply
To see how the concepts covered in this chapter have been applied within Greggs plc, review Chapter 36, p. 373.
Watch out for in practice 
- →Transactions taking place around period ends, especially year ends.
- →Year-on-year changes in debtor, creditor and accruals balances.
- →Revenue recognition accounting policies (see Chapter 6 Revenue recognition).
- →Cash from operations compared to operating profit (see Chapter 5 Cash flow statement).