the accumulation of either revenues or expenses overtime that are impactful to the company’s financial statements, even though cash transaction hasn’t been recorded.
The concept of accruals is closely related to the accrual-based accounting method, which recognizes any transaction immediately after it happened even though cash hasn’t changed hands. For instance, if an electrical power company provides electricity to a customer in credit, the company will record the revenues earned into the ledger instantly after the service is delivered. This would differ if the company applied cash-based accounting instead, which would only take into account transactions after payment is made or received.
Most modern companies use the accrual-based accounting method since it represents a more accurate financial condition and is approved by the generally accepted accounting principles (GAAP). Before the advent of accrual accounting, accountants solely relied on cash-based accounting which wouldn’t give immediate information on essential business events. On the other hand, by using accrual-based accounting, management and analysts alike can more accurately gauge companies’ short-term liabilities and income. Accruals follow the matching principle, which requires revenues and expenses to be recognized regardless of cash exchanges.
Example of Accruals
We’ve talked about how accruals work in terms of revenue. Not only can accruals work in revenue, but companies can also accrue expenses. An example of this is when a company accrues the wage or salary of its employees. In some companies, the work or contribution of workers for this month will only get compensated in the following month. In this case, the accrued liability of the company continues to increase until the wage has been paid off. At the same time, the employees accrue the revenues for this month and will only receive the cash at a later date.
Accrual can also be in the form of interest. For example, a company with long-term debts usually will incur periodical interest that needs to be paid monthly, quarterly, or once every six months. This accrued interest is also a part of accrued expenses.
When it comes to bookkeeping, the necessary adjustment that takes into account accruals is made via adjusting journal entries. An adjusting journal entry is an entry used to record unrecognized expenses and incomes into the components of financial statements, including the balance sheet and income statement. Adjusting journal entries is usually done at the end of each accounting period (e.g. yearly or quarterly).
Types of Accruals
In general, there are two types of accruals: accrued revenues and accrued expenses.
Accrued revenues are not only in the form of cash, but can also include assets and non-cash assets. When a company sells goods or services in credit, the account associated with the transactions is recorded in accounts receivable. Account receivable is an account 一 under the current assets section of the balance sheet 一 that represents the balance of money due to delivered goods or services but not yet paid. Once the payment is received, the account receivable balance is decreased while the cash account is increased.
Accrued expenses are incurred when a company makes any business activity that can turn into a liability in the ledger. Accrued expenses can be in the form of interest expense, supply expense, or salary expense. We’ve already discussed interest and salary expenses. Supply expenses refer to operating expenses for goods and services supplied by a third-party, e.g., office supply. Companies often order their supplies on credit. The account used to record the transactions is accounts payable, which is very similar to accounts receivable, but the company acts as the debtor instead of the creditor.