Accruals are revenues that have been earned or expenses that have been incurred, which impact a company’s net income, even though the associated cash transactions have yet to occur. In essence, accruals ensure that financial events are recognized when they happen, not when cash changes hands.
How Accrual Accounting Works
Accrual accounting is a method that records revenues and expenses when they are incurred, regardless of when cash is exchanged. This approach contrasts with cash accounting, where transactions are recorded only when cash is received or paid.
Revenue Recognition Principle
Under accrual accounting, the revenue recognition principle mandates that revenue is recognized when it is earned and realizable, even if the payment has not been received.
Example: A company completes a service in December but receives the payment in January. Under accrual accounting, the revenue is recognized in December.
Matching Principle
The matching principle dictates that expenses should be recorded in the same period as the revenues they help generate. This ensures that income statements provide an accurate reflection of financial performance.
Example: If a company incurs costs in November to generate revenue that is recognized in December, those costs should also be recognized in December.
Types of Accruals
Accrued Revenues
Accrued revenues are earnings that have been recognized but not yet received in cash.
Example: Interest earned on a loan but not yet received by the lender.
Accrued Expenses
Accrued expenses are costs that have been incurred but not yet paid.
Example: Salaries and wages earned by employees but not yet paid by the company.
Special Considerations
Accrued Liabilities
Accrued liabilities are recorded at the end of an accounting period and include expenses such as interest payable, taxes, and utilities that are due but not yet paid.
Accrued Assets
These are assets that represent revenue earned but not yet collected in cash, such as unbilled services.
Examples of Accrual Accounting
Example 1: Service Fees
A consulting firm completes a project on December 15 but will not receive payment until January 15 of the next year. Under accrual accounting, the firm records the revenue in December.
Example 2: Utility Bills
A company receives a utility bill for December in January. The expense is recorded in December under accrual accounting, even though the payment is made in January.
Historical Context and Applicability
Accrual accounting is essential for larger businesses and public companies as it provides a more accurate picture of financial health. It is mandated by generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS).
Comparisons
Accrual Accounting vs. Cash Accounting
- Accrual Accounting: Records transactions when they occur, regardless of cash flow. Provides a more comprehensive financial picture.
- Cash Accounting: Records transactions only when cash is exchanged. Simpler but may not represent financial health accurately.
Related Terms
Deferred Revenues
Revenues received in advance for services or goods to be delivered in the future.
Prepaid Expenses
Expenses paid in advance for benefits to be received in the future.
FAQs
Why are accruals important?
Can small businesses use accrual accounting?
Summary
Accruals play a vital role in accurate financial reporting by ensuring revenues and expenses are recognized when they occur, not when cash changes hands. This method aligns with key accounting principles and offers a realistic view of a company’s financial status, making it essential for thorough financial analysis.
References
- Financial Accounting Standards Board (FASB)
- International Financial Reporting Standards (IFRS)
- Generally Accepted Accounting Principles (GAAP)
Accrual accounting’s comprehensive approach aids in making informed business decisions and maintaining financial transparency. Understanding its principles and applications is essential for robust financial management and reporting.
