What is Accrual Accounting?
In financial accounting, the term “accruals” are the term used to describe the recording of revenue that the company has earned, but is yet to receive payments for, as well as expenses that were however the business has not yet pay. The approach adheres to the matching principle which stipulates that both revenues and expenses must be recognized within the same time frame for when they were paid for.
The accounting methods, as such can have an effect on the management of the income statement as well as the balance sheet. The affected accounts comprise accounts payable, liabilities , assets that are not cash-based, such as goodwill, tax liabilities for the future as well as future interest costs and other expenses.
What’s an Accrual (in simple English)?
What precisely is “accrual”? If businesses received cash payments for all their revenues in the same period they earned them, as well as also made money payments to cover all costs at the time the expenses were paid, then there would not have a need to accrue. However, as most businesses are able to earn some revenue in the year when they were earned (i.e. the goods or services were rendered) however, the payment was not made and they must keep track of those revenues that were not paid.
The same is true for expenses. If businesses have incurred expenses (i.e. received goods or services) but did not pay for them in cash the expenses must be accumulated.
The objective in accrual-based accounting to align expenses and revenues to the dates at the time they were incurred rather than the time of actual cash flow
1. Accrued Revenues
Accrued revenues can be defined as assets or income (including cash assets) that have yet to be received. In this instance companies may offer goods or services however, it does this through credit.
A good example of accrued revenues is the consumption of electricity. The electricity provider usually offers the service to its customers before receiving the money for it. The user utilizes the electricity, and the meter takes the number of times it is read. At the end of the billing period the consumer is charged. The company is paid its employees, runs its generators and incurs logistics costs as well as other expenses.
The electric company must wait until the close of the month to collect its profits regardless of the expenses during the month that it incurs. It must also admit that it is expecting to earn future profits. Accrual accounting offers the business a way of assessing its financial position more precisely.
The close of the month when the company gets payments from its creditors (customers) receivables go down, and the cash balance increases.
2. Accrued Expenses
The term “accrued expense” refers to when a business purchases with credit and then enters obligations in its general ledger, in order to acknowledge its obligation in its accounts to creditors. In accounting, it’s an expense that is that has not been paid. Common accrued expenses are:
- Accruals of interest – Interest charges which are owed, but not yet paid.
- Amounts due to suppliers Operating expenses for the goods or services provided by a third-party provider.
- Payroll or salary accruals This includes salaries that employees are owed for a portion of the month but have not been paid their full monthly pay.
Let’s look at an example an emerging firm (Y) that has employees (Joe) whom is covered by the cliff vesting program, and also receiving an incentive to vest the schedule for five years’ service. Joe is loyal and hard-working during his time being employed by the business. Joe makes it to the end of his first year and gets his cliff vesting bonus and qualifies for the next five years of the vesting bonus.
But, in this time, Joe is not receiving his bonus in any way, as is the case with cash during the transaction. Instead, the bonuses of Joe are increasing. In parallel, Company Y’s debts have increased.
In this scenario it’s evident it’s obvious that Company Y becomes a debtor to Joe for five years. So, in order to maintain an accurate record of Joe’s bonus payments The company needs to create an obligation to pay bonus to track these bonuses. If the company decides to pay Joe’s bonuses due The transaction is recorded by the company deducting the liability bank account, and then crediting it with a cash account.
Prepaid expenses as opposed to. Accrued Expenses
The prepaid expense is the opposite to accrued expenses. Instead of delaying payments until a later date, companies pay in advance for goods and services even if it doesn’t receive the entire amount of items or services in one go at the moment of payment. For instance, a company might be able to pay monthly for internet service early, at the beginning of each month, prior to when it even uses the service.
Impact of Accrual Accounting
Alongside accruals, which add an additional layer of accounting data to the existing data They also alter how accountants conduct their recording. Accruals can actually help in dispelling the confusion in accounting relating to the liabilities and revenue. This means that businesses are able to anticipate revenue while also keeping liabilities under control.
Accruals aid accountants in identifying and monitoring the potential for issues with profitability or cash flow and assist in determining an appropriate solution for these issues.
To track accruals, an accountant has to apply an accounting concept called”the accrual” method. The accrual method allows the accountant to record the data, alter it, and track “as yet unrecorded” earned revenue and expenses. To make the data useful in financial statements the accountant has to adjust journal entries consistently and precisely and also be reliable.
The Relationship Between Accounting for Accrual Accounting as well as Cash Accounting
Although both cash accounting are used as a gauge of performance as well as the economic situation of a firm during a particular year, the cash accounting transactions are recorded in the order they occur – both credits and debits. However, the reporting of cash accounting transactions is recorded during cash transactions.
FASB and IFRS Example
The Financial Accounting Standards Boards (FASB) has issued Generally Accepted Accounting Principles (GAAP) in the U.S. dictating when and the way companies should be able to accrue certain aspects. For instance, “Accounting for Compensated Absences” will require employers to incur an obligation for future vacation days of employees. Find out more about this specific example on the FASB’s site.