Accruals: expenses incurred but not yet paid or revenues earned but not yet received that affect a company’s bottom line on the income statement.
According to the dictionary, “accruals” is a synonym for “accumulation.” When a company accrues income or expenses, it accumulates this income or liabilities over time but without a cash exchange. Some examples of accruals include—but are not limited to—accrued income, accrued expenses, accounts receivable, and accounts payable.
The inclusion of accruals into the income statement is the result of accrual accounting. When a company adopts accrual accounting, it will post a transaction to the general ledger regardless of whether they receive or pay cash. Accrual accounting contrasts with cash accounting, in which a company will only make transaction entries if there’s a cash inflow or outflow. Bookkeepers include accruals through adjusting journal entries at the end of each period.
Even though accruals account for unpaid transactions, people regard them on financial statements as more accurate. This is true since accruals reveal important business activities such as income earned through credit and potentially hidden liabilities. On the other hand, cash accounting won’t provide clear information as it records only paid transactions. This is why most modern companies prefer to use accrual accounting.
A manufacturing company needs utilities to keep the company operational, one of which is electricity. To meet its need, the business relies on a utility company that will generate electricity for them. The utility company sells the service in credit and will only send an electricity bill for the current month at the beginning of the next month. Furthermore, not only yearly, the manufacturing company reports financial statements monthly as well.
The manufacturing company needs to record the accrual on the financial statements, reflecting unpaid electricity expenses. More specifically, the company will post the following entries at the end of the current month: a debit to utility expense on the income statement and a credit to accrued liability on the balance sheet.
Accrual can also be in the form of interest. If the manufacturing company borrows money from a bank, it will also record debt interest expense for its monthly financial statements. This form of accrual is called accrued interest, which is also a part of accrued expense. The amount of accrued interest posted on the general ledger equal the accumulated interest expense as of the time at which adjusting journal entry is made.
Types of Accruals
There are many types of accounts that are considered accruals. However, they can generally be divided into two categories.
- Accrued Income & Accounts Receivable
Accrued income is an earning a company has earned but not yet billed and received. For perspective, let’s consider the utility company in the previous example. The company's accumulated income through electricity is an example of accrued income—the service revenue is not yet invoiced and received. Once the company sends an invoice, accrued income becomes accounts receivable. The difference between Accrued Income and Accounts Receivable is whether they’re billed or not, but both are unpaid revenue.
- Accrued Expense & Accounts Payable
In contrast to accrued income, accrued expense is a liability a company has incurred but not yet billed and paid. One example is when a company accrues the salary of its employees in the current month. Most companies usually pay their workers’ contribution during the current month at the beginning of next month. Accrued salary is a type of accrued expense. However, once the salary invoices are made, accrued expense becomes accounts payable, also known as salary payable.