What Are Accruals?
Accruals are revenues earned or expenses incurred that impact a company's net income on the income statement but cash related to the transaction hasn't yet changed hands. Accruals also affect the balance sheet because they involve non-cash assets and liabilities.
The revenue from a service would be recorded as an accrual in a company's financial statements if the company has performed a service for a customer but hasn't yet received payment. This ensures that the company's financial statements accurately reflect its true financial position even if it hasn't yet received payment for all the services it's provided.
Accrual accounts include accounts payable, accounts receivable, accrued tax liabilities, and accrued interest earned or payable among many others.
Key Takeaways
- Accruals are necessary for any revenue earned or expense incurred for which cash hasn't yet been exchanged.
- Accruals improve the quality of information on financial statements by adding useful details about short-term credit extended to customers and upcoming liabilities owed to lenders.
- Accruals and deferrals are the basis of the accrual method of accounting.
- This is the preferred method of accounting according to GAAP.
- Accruals are created by adjusting journal entries at the end of each accounting period.
Understanding Accruals
An accrual is a record of revenue or expenses that have been earned or incurred but haven't yet been recorded in the company's financial statements. This can include things like unpaid invoices for services provided or expenses that have been incurred but not yet paid.
Accruals are important because they help to ensure that a company's financial statements accurately reflect its true financial position even if it hasn't yet received payment for all the services it has provided or paid all its bills.
Revenue is recognized when it's earned in accrual-based accounting regardless of when the payment is received. The revenue received from a service would be recorded in December when it was earned if a company provided a service to a customer in December but didn't receive payment until January of the following year.
Expenses are recorded when they're incurred regardless of when they're paid. An expense would be recorded in December if a company incurs expenses in December for a service that will be received in January. Revenue derived from that service would be recorded in December when it was earned.
The Accrual Method of Accounting
Accruals and deferrals are the basis of the accrual method of accounting, the preferred method by generally accepted accounting principles (GAAP). An accountant makes adjustments for revenue that's been earned but not yet recorded in the general ledger and expenses that have been incurred but are also not yet recorded.
The accruals are made via adjusting journal entries at the end of each accounting period so the reported financial statements can be inclusive of these amounts.
The use of accrual accounts greatly improves the quality of information on financial statements. Accountants only recorded cash transactions before the use of accruals. Unfortunately, cash transactions don't give information about other important business activities such as revenue based on credit extended to customers or a company's future liabilities.
A company can measure what it owes in the short term and also what cash revenue it expects to receive by recording accruals. It also allows a company to record assets that don't have a cash value such as goodwill.
The offset to an accrued expense is an accrued liability account in double-entry bookkeeping. This appears on the balance sheet. The offset to accrued revenue is an accrued asset account and this also appears on the balance sheet. An adjusting journal entry for an accrual will therefore impact both the balance sheet and the income statement.
Accrual accounting is the preferred method according to generally accepted accounting principles (GAAP). It's widely considered to provide a more accurate and comprehensive view of a company's financial position and performance than the cash basis of accounting which only records transactions when cash is exchanged.
Recording Accruals on the Income Statement and Balance Sheet
The company must make journal entries to record accruals on the balance sheet to reflect the revenues and expenses that have been earned or incurred but not yet recorded. A company would make a journal entry to record the revenue from that service as an accrual if it's provided a service to a customer but hasn't yet received payment. This would involve debiting the "accounts receivable" account and crediting the "revenue" account on the income statement.
The company would make a journal entry to record the expenses as an accrual if it has incurred expenses but has not yet paid them. This would involve debiting the "expenses" account on the income statement and crediting the "accounts payable" account.
Example of Accruals
Let's look at an example of a revenue accrual for a utility company.
Accounts Payable
An example of an accrued expense for accounts payable could be the cost of electricity that the utility company has used to power its operations but hasn't yet paid for. The utility company would make a journal entry to record the cost of the electricity as an accrued expense in this case. This would involve debiting the "expense" account and crediting the "accounts payable" account.
The effect of this journal entry would be to increase the utility company's expenses on the income statement and to increase its accounts payable on the balance sheet.
Another example of an expense accrual involves employee bonuses that were earned in 2023 but won't be paid until 2024. The 2023 financial statements must reflect the bonus expenses earned by employees in 2023 as well as the bonus liability the company plans to pay out. An adjusting journal entry therefore records this accrual with a debit to an expense account and a credit to a liability account before issuing the 2023 financial statements.
The liability account will be decreased through a debit and the cash account will be reduced through a credit when the payment is made in the new year.
Accounts Receivable
The utility company generated electricity that customers received in December but it doesn't bill the electric customers until the following month when the meters have been read. The company must complete an adjusting journal entry to report the revenue that was earned in December to have the proper revenue figure for the year on the utility's financial statements.
It will also be reflected in the receivables account as of December 31 because the utility company has fulfilled its obligations to its customers in earning the revenue at that point. The adjusting journal entry for December would include a debit to accounts receivable and a credit to a revenue account. The company would record a credit to decrease accounts receivable and a debit to increase cash the following month when the cash is received.
Accrued Interest
Another expense accrual occurs for interest. A company with a bond will accrue interest expense on its monthly financial statements even though interest on bonds is typically paid semi-annually. The interest expense recorded in an adjusting journal entry will be the amount that's accrued as of the financial statement date. A corresponding interest liability will be recorded on the balance sheet.
What Is the Purpose of Accruals?
The purpose of accruals is to ensure that a company's financial statements accurately reflect its true financial position. This is important because financial statements are used by a wide range of stakeholders to evaluate the financial health and performance of a company including investors, creditors, and regulators.
A company's financial statements would only reflect the cash inflows and outflows without accruals rather than the true state of its revenues, expenses, assets, and liabilities. Accruals provide a more accurate picture of a company's financial position by recognizing revenues and expenses when they're earned or incurred rather than only when payment is received or made,
What Are the Types of Accruals?
Some types of accruals include accrued revenues. These refer to the recognition of revenues that have been earned but not yet recorded in the company's financial statements. The revenue received for a service would be recorded as an accrual in December when it was earned if a company provides a service to a customer in December but doesn't receive payment until January of the following year.
Accrued expenses refer to the recognition of expenses that have been incurred but not yet recorded in the company's financial statements. The expenses would be recorded as an accrual in December when they were incurred if a company incurs expenses in December for a service that will be received in January.
Accrued interest refers to interest that's been earned on an investment or a loan but hasn't yet been paid. It would be recorded as an accrual on the company's financial statements if the firm has a savings account that earns interest and the interest has been earned but not yet paid.
Is an Accrual a Credit or a Debit?
It depends on the type of accrual and the effect it has on the company's financial statements.
The journal entry would involve a credit to the revenue account and a debit to the accounts receivable account for accrued revenues. This has the effect of increasing the company's revenue and accounts receivable on its financial statements.
The journal entry would involve a debit to the expense account and a credit to the accounts payable account for accrued expenses. This has the effect of increasing the company's expenses and accounts payable on its financial statements.
What Is the Journal Entry for Accruals?
The rules for recording accruals are generally the same as the rules for recording other transactions in double-entry accounting. The specific journal entries will depend on the individual circ*mstances of each transaction.
The Bottom Line
Accruals impact a company's bottom line even though cash has not yet changed hands. The accrual method of accounting is the preferred method according to GAAP and involves making adjustments for revenue that have been earned but are not yet recorded and expenses that have been incurred but are not yet recorded. This is accomplished by adjusting journal entries at the end of the accounting period.
Accruals are important because they help to ensure that a company's financial statements accurately reflect its actual financial condition.
