Mastering Accruals: Revealing the True Financial Picture
Accruals are revenues earned or expenses incurred that impact a company’s net income on the income statement, even though cash related to the transaction has not yet changed hands. Accruals also affect the balance sheet as they involve non-cash assets and liabilities. For instance, if a company has performed a service for a customer but has not yet received payment, the revenue from that service would be recorded as an accrual in the company’s financial statements. This ensures the company’s financial statements accurately reflect its true financial position, even if the payment is pending.
Key Takeaways
- Accruals are crucial for revenues earned or expenses incurred, even without cash transactions.
- Accruals enhance financial statements by adding information about short-term credit extended to customers and upcoming liabilities owed to lenders.
- Accruals and deferrals form the basis of the accrual method of accounting.
- This method is preferred according to GAAP.
- Accruals are established by adjusting journal entries at the end of each accounting period.
Grasping the Concept of Accruals
Accruals document revenues or expenses earned or incurred but not recorded in the financial statements. This includes unpaid invoices for provided services or incurred expenses not yet paid. Accruals ensure the financial statements accurately represent the company’s true financial situation, encompassing all provided services or owed payments.
In accrual-based accounting, revenue is recognized when earned, regardless of when received. For example, if a company provides a service in December but receives payment in January, the revenue records in December, aligning with its earnings. Similarly, expenses are recorded when incurred, regardless of their payment. For instance, a service received in January but incurred in December is recorded in December.
The Accrual Method of Accounting
Accruals and deferrals establish the accrual method of accounting, preferred under GAAP. Accountants adjust for earned but unrecorded revenue and incurred but unrecorded expenses in the general ledger through adjusting journal entries at the end of each accounting period. This inclusion significantly enhances the quality of financial reports. Historically, only cash transactions were recorded, omitting critical details about credit-based revenue or future liabilities. Accruals address this by showcasing short-term dues and expected revenue. Assets with no cash value, like goodwill, are also recorded.
Recording Accruals
To include accruals in the balance sheet, journal entries reflecting unrecorded revenues and expenses are made. For instance, for unpaid service revenue, an entry debits ‘accounts receivable’ and credits ‘revenue.’ For incurred but unpaid expenses, an entry debits ’expenses’ and credits ‘accounts payable.’
Inspiring Examples of Accruals
Accounts Payable
Consider an accrued expense for accounts payable like electricity used by a utility company but unpaid. The company records this by debiting the ’expense’ account and crediting ‘accounts payable,’ impacting both the income statement (higher expenses) and the balance sheet (higher accounts payable).
Another case involves year-end bonuses earned but unpaid until the following year. Financial statements must reflect the bonus expense and liability for the period earned through an adjusting journal entry. Once paid, the liability decreases, balancing the entries.
Accounts Receivable
If a utility company provides electricity in December but bills customers in January, an adjusting journal entry records the revenue due for December, debiting receivables and crediting revenue. When payments are collected, accounts receivable decrease, and cash increases.
Accrued Interest
For a company with bonds accruing interest monthly but paid semi-annually, the monthly accrued interest records as an expense with a corresponding interest liability in the financial statements.
The Purpose of Accruals
Accruals guarantee financial statements genuinely represent a company’s financial condition, aiding stakeholders (investors, creditors, regulators) in evaluating financial health and performance. Accruals showcase the financial picture by recording revenues and expenses when earned or incurred, rather than only when paid.
Types of Accruals
- Accrued Revenues: Recognize earned but unrecorded revenues, like services rendered in December but paid in January.
- Accrued Expenses: Recognize incurred but unrecorded expenses, like December’s expenses for services received in January.
- Accrued Interest: Recognizes interest earned but unpaid on investments or loans.
Accrual Entries: Debits and Credits in Harmony
The nature of an accrual—be it a debit or credit—depends on its business impact. Accrued revenue increases both the revenue account (credit) and accounts receivable (debit). Conversely, accrued expenses increase both the expense account (debit) and accounts payable (credit).
Journal Entries for Accruals
Journal entry rules for accruals align with double-entry accounting principles, with entries reflecting the specifics of each transaction.
The Bottom Line
Accruals significantly impact a company’s finances by recording revenues and expenses before cash exchanges occur. The accrual method, preferred by GAAP, ensures accurate financial reporting through end-period adjusting journal entries that truly reflect a company’s financial state.
Related Terms: net income, income statement, balance sheet, accounts payable, accounts receivable, accrued tax liabilities, accrued interest
References
- Internal Revenue Service. “Publication 538, Accounting Periods and Methods”. Page 10.
