What is an Accrual?
Definition: Accrual represents revenues and expense, which are not recorded on a firm’s balance sheet; however, they have an impact on the firm’s income and assets that are based on accrual accounting, such as accounts receivable, accounts payable and interest expenses.
Accrual (accumulation) of something is, in finance, the adding together of interest or different investments over a period of time. It holds specific meanings in accounting, where it can refer to accounts on a balance sheet that represent liabilities and non-cash-based assets used in accrual-based accounting. These types of accounts include, among others, accounts payable, accounts receivable, goodwill, deferred tax liability and future interest expense.
What Does Accrual Mean?
What is the definition of accrual? Accrual accounting recognizes adjustments for revenues that are realized by the delivery of the product or the service. Hence, cash has been received, and the revenue needs to be recognized on the balance sheet. It also recognizes expenses related to the recognized revenue, so that the entries in the financial statement match these accrued revenues and expenses. For instance, an employee bonus is an expense for the company. However, it the bonus is earned in the first quarter (Q1), and it is paid in the fourth quarter (Q4), this is an accrued expense for the company. In the financial statements of the next year, the company should record the bonus as an expense.
Accruals and deferrals are the basis of the accrual method of accounting, the preferred method by generally accepted accounting principles (GAAP). Using the accrual method, an accountant makes adjustments for revenue that has been earned but is 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. Before the use of accruals, accountants only recorded cash transactions. 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. By recording accruals, a company can measure what it owes in the short-term and also what cash revenue it expects to receive. It also allows a company to record assets that do not have a cash value, such as goodwill.
In double-entry bookkeeping, the offset to an accrued expense is an accrued liability account, which appears on the balance sheet. The offset to accrued revenue is an accrued asset account, which also appears on the balance sheet. Therefore, an adjusting journal entry for an accrual will impact both the balance sheet and the income statement.
Why Use Accruals?
The use of accruals allows a business to look beyond simple cash flow. In a cash-based accounting approach, a company records only the transactions where cash changes hands. Accruals form the base for accrual accounting and incorporate all transactions, including accounts receivable, accounts payable, employee salaries, etc. Recording an amount as an accrual provides a company with a more comprehensive look at its financial situation. It provides an overview of cash owed and credit given, and allows a business to view upcoming income and expenses in the following fiscal period.
Accruals are used for:
- benefits that have already been taken by the company but for which payment has not yet been made, or
- services that have already have been provided but for which payment has not yet been received
Utility bills are the most common example of accruals.
Company XYZ has a manufacturing facility and uses water and electricity from utility companies. The utility companies issue their invoices on a billing cycle, which runs from the 20th of the current month to the 19th of the following month. So, company XYZ receives the current utility bills on the 23rd of the following month and not before.
At the beginning of each month, let’s say, February, the accountant of company XYZ closes the previous month, i.e. January. Because the utility companies do not bill their customers for the current month but for the next month, the accountant pays the utility bills of January in February and of February in March and so on. Therefore, the company’s accountant has to adjust the entries in the financial statement so that the payments of the bills are reported as accrued expenses.
For example, a company delivers a product to a customer who will pay for it 30 days later in the next fiscal year, which starts a week after the delivery. The company recognizes the proceeds as a revenue in its current income statement still for the fiscal year of the delivery, even though it will not get paid until the following accounting period. The proceeds are also an accrued income (asset) on the balance sheet for the delivery fiscal year, but not for the next fiscal year when cash is received.
Similarly, a salesperson, who sold the product, earned a commission at the moment of sale (or delivery). The company will recognize the commission as an expense in its current income statement, even though the salesperson will actually get paid at the end of the following week in the next accounting period. The commission is also an accrued liability on the balance sheet for the delivery period, but not for the next period when the commission (cash) is paid out to the salesperson.
The term accrual is also often used as an abbreviation for the terms accrued expense and accrued revenue that share the common name word, but they have the opposite economic/accounting characteristics.
Types of Accruals
There are a few types of accruals, but most fall under one of the two main types: revenue accruals and expense accruals.
Revenue: when services or goods have been provided by the company, but payment has not yet been received. An example is rent for an office space that has not yet been paid in full but is expected to be paid in the next fiscal period.
Expense: when services or goods have been received by a company, but for which payment has not yet been made. For example, an account receivable. In other words, a company receives a mobile phone bill in January for a past period (December of the previous year), this would be recorded as an expense accrual.
Accrued revenue (or accrued assets) is an asset, such as unpaid proceeds from a delivery of goods or services, when such income is earned and a related revenue item is recognized, while cash is to be received in a later period, when the amount is deducted from accrued revenues.
In the rental industry, there are specialized revenue accruals for rental income which crosses month end boundaries. These are normally utilized by rental companies who charge in arrears, based on an anniversary of a contract date. For example, a rental contract which began on 15 January, being invoiced on a recurring monthly basis will not generate its first invoice until 14 February. Therefore, at the end of the January financial period an accrual must be raised for sixteen days’ worth of the monthly charge. This may be a simple pro-rate basis (e.g. 16/31 of the monthly charge) or may be more complex if only week days are being charged or a standardized month is being used (e.g. 28 days, 30 days etc.)
Example of an Accrual of Revenues
One example of an accrual of revenues occurs at your electric utility company. For instance, during December the utility likely uses natural gas and/or coal plus many employees to generate the electricity used by its customers in December. However, the utility does not bill its customers for that electricity until after it reads the meters in January. As a result, the utility’s financial statements will need an accrual adjustment so that:
- its income statement for the month of December and for the current year will report all of the revenues earned by the utility, and
- its December 31 balance sheet will report a current asset for the amount it has a right to receive from its customers (including the amount for the electricity it provided in December)
The accrual adjustment will debit the current asset account Accrued Receivables and will credit the income statement account Accrued Electricity Revenues.
Accrued expense is a liability whose timing or amount is uncertain by virtue of the fact that an invoice has not yet been received. The uncertainty of the accrued expense is not significant enough to qualify it as a provision. An example of an accrued expense is a pending obligation to pay for goods or services received from a counterpart, while cash is to be paid out in a later accounting period when the amount is deducted from accrued expenses.
Under International Financial Reporting Standards, this difference is best summarized by IAS 37 which states:
- 11 Provisions can be distinguished from other liabilities such as trade payables and accruals because there is uncertainty about the timing or amount of the future expenditure required in settlement. By contrast:
- “(a) trade payables are liabilities to pay for goods or services that have been received or supplied and have been invoiced or formally agreed with the supplier; and
- “(b) accruals are liabilities to pay for goods or services that have been received or supplied but have not been paid, invoiced or formally agreed with the supplier, including amounts due to employees (for example, amounts relating to accrued vacation pay). Although it is sometimes necessary to estimate the amount or timing of accruals, the uncertainty is generally much less than for provisions.
Accruals are often reported as part of trade and other payables, whereas provisions are reported separately.
Example of an Accrual of an Expense
One example of an accrual of an expense and liability is a major repair that occurs in the final month of the accounting year, but is not paid until the bill is received in the first month of the following year. For the current year’s financial statements to be complete (under the accrual method of accounting) the following is necessary:
- the income statement for the current year must report the repair expense, and
- the balance sheet as of the last day of the year must report the related liability
To record this accrual, an adjusting entry is made that debits Repairs Expense and credits Accrued Expenses Payable.
To add to the confusion, some legalistic accounting systems take a simplistic view of ‘accrued revenue’ and ‘accrued expenses’, defining each as revenue or expense that has not been formally invoiced. This is primarily due to tax considerations, since in some countries, the act of issuing an invoice creates taxable revenue, even if the customer does not ultimately pay and the related receivable becomes noncollectable.