Accrue: Definition, Mechanisms, and Key Types of Accruals in Financial Accounting

What are Accruals?

Definition

Accruals are revenues earned or expenses incurred that impact a company’s net income, even though cash has not yet changed hands. These involve non-cash assets and liabilities and are vital for ensuring compliance with the matching principle. For instance, if a company provides services in December but does not receive payment until January, the revenue from those services is still recognized in December under accrual accounting.

Mechanism

Accruals are recorded through adjusting journal entries at the end of each accounting period to ensure that financial statements include these amounts. This process involves double-entry bookkeeping, where an accrued expense is offset by an accrued liability account, and accrued revenue is offset by an accrued asset account. For example, if a company incurs a major repair in December but does not pay for it until January, it would debit the repair expense account and credit the accrued expenses payable account.

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Accrual Accounting Method

Overview

Accrual accounting is an accounting method that recognizes revenue when it is earned and expenses when they are incurred, regardless of when cash is received or paid. This contrasts with cash basis accounting, which only records transactions when cash changes hands. Accrual accounting provides a more comprehensive view of a company’s financial health because it reflects all economic activities during the period.

Key Principles

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The matching principle is central to accrual accounting. It states that revenues and expenses should be reported in the same period to provide an accurate picture of profitability. Both International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP) encourage the use of accrual accounting for this reason.

Types of Accruals

Accrued Expenses

Accrued expenses are costs incurred by a business but not yet paid for. For example, if a company’s employees work in December but are paid in January, the wages for December would be recorded as an accrued expense. This is done by debiting the wage expense account and crediting the accrued wages payable account.

Accrued Revenues

Accrued revenues refer to income earned by a business but not yet received. A common example is a utility company that provides electricity in December but bills its customers in January. The revenue from the electricity provided in December would be recognized as accrued revenue, recorded by debiting the accrued revenue receivable account and crediting the revenue account.

Deferred Revenue

Deferred revenue, also known as unearned revenue, occurs when cash is received before goods or services are delivered. For instance, if you pay for a gym membership in January that covers services from January to December, the gym would record this as deferred revenue until it provides the services. Initially, it would debit the cash account and credit the deferred revenue account; as services are provided throughout the year, it would gradually recognize this as revenue.

Examples and Scenarios

Purchase Order Accruals

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When goods are received but not yet paid for, purchase order accruals come into play. Suppose a company receives lab equipment in June but does not receive the invoice until July. The cost of the equipment would be recorded as an accrued expense in June to reflect the economic activity accurately.

Utility Bills and Services

Accruals are also necessary for services provided over multiple periods. For example, if a company uses electricity throughout December but receives the bill in January, it must record an accrued expense for the electricity used in December to ensure accurate financial reporting.

Importance and Advantages

Financial Statement Accuracy

Accruals ensure that financial statements accurately reflect a company’s true financial position by including all economic activities during the period. This method provides a more comprehensive view than cash basis accounting because it accounts for revenues and expenses regardless of when cash changes hands.

Stakeholder Use

Financial statements prepared using accrual accounting are invaluable to stakeholders such as investors, creditors, and regulators. These stakeholders rely on these statements to evaluate a company’s financial health and performance accurately.

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