Posts Tagged ‘January’

Asian Financial Crisis: Causes, Response, Lessons Learned

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Asian Financial Crisis: Causes, Response, Lessons Learned

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What Was the Asian Financial Crisis?

The Asian financial crisis, also called the “Asian Contagion,” was a sequence of currency devaluations and other events that began in July 1997 and spread across Asia. The crisis started in Thailand when the government ended the local currency’s de facto peg to the U.S. dollar after depleting much of the country’s foreign exchange reserves trying to defend it against months of speculative pressure.

Just weeks after Thailand stopped defending its currency, Malaysia, the Philippines, and Indonesia were also compelled to let their currencies fall as speculative market pressure built. By October, the crisis spread to South Korea, where a balance-of-payments crisis brought the government to the brink of default.

Other economies also came under pressure, but those with solid economic fundamentals and hefty foreign exchange reserves fared much better. Hong Kong fended off several major but unsuccessful speculative attacks on its currency, which is pegged to the U.S. dollar via a currency board system and backed by massive U.S. dollar reserves. 

Key Takeaways

  • The Asian financial crisis started in July 1997, when Thailand stopped defending the baht after months of downward market pressure, causing the currency to fall quickly.
  • The contagion spread quickly, with currencies across the region falling—some quite catastrophically.
  • The crisis was rooted in economic growth policies that encouraged investment but also created high levels of debt (and risk) to finance it.
  • The International Monetary Fund (IMF) bailed out many countries but imposed strict spending restrictions in exchange for the help.
  • Affected countries have since put in place mechanisms to avoid creating the same scenario in the future.

Impact of the Asian Financial Crisis

As the Thai baht fell, other Asian currencies fell—some precipitously. Across Asia, inflows of capital slowed or reversed.

The Thai baht had been trading at about 26 to the U.S. dollar before the crisis but lost half its value by the end of 1997, falling to 53 to the dollar by January 1998. The South Korean won fell from about 900 to the dollar to 1,695 by the end of 1997. The Indonesian rupiah, which had been trading at around 2,400 to the dollar in June 1997, plummeted to 14,900 by June 1998, less than one-sixth its precrisis level.

Some of the more heavily affected countries fell into severe recession. Indonesia’s gross domestic product (GDP) growth fell from 4.7% in 1997 to -13.1% in 1998. In the Philippines, it slid from 5.2% to -0.5% over the same period. Malaysia’s GDP growth similarly slid from 7.3% in 1997 to -7.4% in 1998, while South Korea’s contracted from 6.2% to -5.1%.

In Indonesia, the ensuing economic crisis led to the collapse of the three-decade-old dictatorship of President Suharto.

The crisis was alleviated by intervention from the International Monetary Fund (IMF) and The World Bank, among others, which poured some $118 billion into Thailand, Indonesia, and South Korea to bail out their economies.

As a result of the the crisis, affected countries restructured their economies, generally because the IMF required reform as a condition of help. The specific policy changes were different in each country but generally involved strengthening weak financial systems, lowering debt levels, raising interest rates to stabilize currencies, and cutting government spending.

The crisis also serves as a valuable case study for economists to understand how interwoven markets affect one another, especially as it relates to currency trading and national accounts management.

Causes of the Asian Financial Crisis

The crisis was rooted in several threads of industrial, financial, and monetary government policies and the investment trends that they created. Once the crisis began, markets reacted strongly, and one currency after another came under pressure. Some of the macroeconomic problems included current account deficits, high levels of foreign debt, climbing budget deficits, excessive bank lending, poor debt-service ratios, and imbalanced capital inflows and outflows.

Many of these problems were the result of policies to promote export-led economic growth in the years leading up to the crisis. Governments worked closely with manufacturers to support exports, including providing subsidies to favored businesses, more favorable financing, and a currency peg to the U.S. dollar to ensure an exchange rate favorable to exporters.

While this did support exports, it also created risk. Explicit and implicit government guarantees to bail out domestic industries and banks meant investors often did not assess the profitability of an investment but instead looked to its political support. Investment policies also created cozy relationships among local conglomerates, financial institutions, and the regulators who oversaw their industries. Large volumes of foreign money flowed in, often with little attention to potential risks. These factors all contributed to a massive moral hazard in Asian economies, encouraging major investment in marginal and potentially unsound projects.

As the crisis spread, it became clear that the impressive economic growth rates in these countries were concealing serious vulnerabilities. In particular, domestic credit had expanded rapidly for years, often poorly supervised, creating significant leverage along with loans extended to dubious projects. Rapidly rising real estate values (often fueled by easy access to credit) contributed to the problem, along with rising current account deficits and a buildup in external debt. Heavy foreign borrowing, often at short maturities, also exposed corporations and banks to significant exchange rate and funding risks—risks that had been masked by long-standing currency pegs. When the pegs fell apart, companies that owed money in foreign currencies suddenly owed a lot more in local currency terms, forcing many into insolvency.

Many Asian economies had also slid into current account deficits. If a country has a current account surplus, that means it is essentially a net lender to the rest of the world. If the current account balance is negative, then the country is a net borrower from the rest of the world. Current account deficits had grown on the back of heavy government spending (much of it directed to supporting continued export growth).

Response to the Asian Financial Crisis

The IMF intervened to stem the crisis with loans to stabilize the affected economies. The IMF and others lent roughly $118 billion in short-term loans to Thailand, Indonesia, and South Korea. The bailouts came with conditions, though: Governments had to raise taxes, cut spending, and eliminate many subsidies. By 1999, many of the affected countries began to show signs of recovery.

Other financial institutions also intervened. For example, in December 1997, the U.S. Federal Reserve Bank brokered a deal under which U.S. banks owed money by South Korean companies on short-term loans voluntarily agreed to roll them over into medium-term loans.

Lessons from the Asian Financial Crisis

Many of the lessons of the Asian financial crisis remain relevant today. First, beware of asset bubbles, as they have a habit of bursting. Another is that governments need to control spending and pursue prudent economic development policies.

How do government spending and monetary policy affect a currency’s value?

When governments spend, implement policies that keep taxes low, subsidize the price of staple goods, or use other methods that effectively put more money in people’s pockets, consumers have more money to spend. As most economies rely at least partly on imports for many goods and services, this increased spending creates demand for foreign currency (usually U.S. dollars), as importers have to sell local currency and buy foreign currency to pay for imports.

Demand for foreign currency (and selling of local currency to buy it) increases exponentially when those policies also promote heavy investment in infrastructure, new businesses, and other economic projects. As more local currency is offered for sale on foreign exchange markets, its value goes down, unless there is a corresponding demand to buy it (say, by exporters selling foreign currency that they earn from exports).

Why do governments keep exchange rates high?

Governments, especially in developing economies, seek to manage exchange rates to balance their ability to pay debts denominated in foreign currencies. Because investors generally prefer instruments denominated in more stable currencies, governments in developing economies often raise funds by issuing bonds denominated in U.S. dollars, Japanese yen, or euros.

However, if the value of the domestic currency falls vs. the currency in which its debt is denominated, that effectively increases the debt, as more local currency is needed to pay it. So, when the Thai baht lost half of its value in 1997, that meant local borrowers needed twice as many baht to pay debts denominated in U.S. dollars. As many developing countries also rely on imports, a higher-valued local currency also makes those imports cheaper in local currency terms.

Why do governments keep exchange rates low?

Conversely, governments may seek to keep their exchange rates low to increase the competitiveness of exports.

In the 1980s, following years of complaints from U.S. companies about competition from cheap Japanese imports, the U.S. government convinced Japan to allow its currency to appreciate as part of the Plaza Accord. The currency’s value climbed from 250 yen to one U.S. dollar in early 1985 to less than 130 yen by 1990. The U.S. trade deficit with Japan fell from $55 billion in 1986 to $41 billion in 1990.

The Bottom Line

In 1997, decades of economic policy planning that featured close relationships among government policy planners, regulators, the industries they regulated, and financial institutions came to a head when markets began putting downward pressure on Asian currencies. The most vulnerable were those countries with high levels of debt and insufficient financing to pay it.

The IMF stepped in to bail out the most affected economies, but it imposed strict conditions in exchange for the help. Some measures included requiring governments to cut spending, raise taxes, eliminate subsidies, and restructure their financial systems.

The crisis also serves as a case study in asset bubbles and how quickly panic selling can trigger contagion that central bankers cannot control.

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What Are Alternative Investments? Definition and Examples

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What Are Alternative Investments? Definition and Examples

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What Is an Alternative Investment?

An alternative investment is a financial asset that does not fall into one of the conventional investment categories. Conventional categories include stocks, bonds, and cash. Alternative investments can include private equity or venture capital, hedge funds, managed futures, art and antiques, commodities, and derivatives contracts. Real estate is also often classified as an alternative investment.

Key Takeaways

  • An alternative investment is a financial asset that does not fit into the conventional equity/income/cash categories.
  • Private equity or venture capital, hedge funds, real property, commodities, and tangible assets are all examples of alternative investments.
  • Most alternative investments have fewer regulations from the U.S. Securities and Exchange Commission (SEC) and tend to be somewhat illiquid.
  • While traditionally aimed at institutional or accredited investors, alternative investments have become feasible to retail investors via alternative funds.

Understanding Alternative Investments

Most alternative investment assets are held by institutional investors or accredited, high-net-worth individuals because of their complex nature, lack of regulation, and degree of risk. Many alternative investments have high minimum investments and fee structures, especially when compared to mutual funds and exchange-traded funds (ETFs). These investments also have less opportunity to publish verifiable performance data and advertise to potential investors. Although alternative assets may have high initial minimums and upfront investment fees, transaction costs are typically lower than those of conventional assets due to lower levels of turnover.

Most alternative assets are fairly illiquid, especially compared to their conventional counterparts. For example, investors are likely to find it considerably more difficult to sell an 80-year old bottle of wine compared to 1,000 shares of Apple Inc. due to a limited number of buyers. Investors may have difficulty even valuing alternative investments, since the assets, and transactions involving them, are often rare. For example, a seller of a 1933 Saint-Gaudens Double Eagle $20 gold coin may have difficulty determining its value, as there are only 13 known to exist and only one can be legally owned.

Regulation of Alternative Investments

Even when they don’t involve unique items like coins or art, alternative investments are prone to investment scams and fraud due to the lack of regulations.

Alternative investments are often subject to a less clear legal structure than conventional investments. They do fall under the purview of the Dodd-Frank Wall Street Reform and Consumer Protection Act, and their practices are subject to examination by the U.S. Securities and Exchange Commission (SEC). However, they usually don’t have to register with the SEC. As such, they are not overseen or regulated by the SEC as are mutual funds and ETFs.

So, it is essential that investors conduct extensive due diligence when considering alternative investments. In some cases, only accredited investors may invest in alternative offerings. Accredited investors are those with a net worth exceeding $1 million—not counting their primary residence—or with an annual income of at least $200,000 (or $300,000 combined with a spousal income). Financial professionals who hold a FINRA Series 7, 65, or 82 license may also qualify as an accredited investor.

Some alternative investments are only available to accredited investors—e.g., those with a net worth above $1 million, or an annual income of at least $200,000.

Strategy for Alternative Investments

Alternative investments typically have a low correlation with those in standard asset classes. This low correlation means they often move counter to the stock and bond markets. This feature makes them a suitable tool for portfolio diversification. Investments in hard assets, such as gold, oil, and real property, also provide an effective hedge against inflation, which hurts the purchasing power of paper money.

Because of this, many large institutional funds such as pension funds and private endowments often allocate a small portion of their portfolios—typically less than 10%—to alternative investments such as hedge funds.

The non-accredited retail investor also has access to alternative investments. Alternative mutual funds and exchange-traded funds—also called alt funds or liquid alts—are now available. These alt funds provide ample opportunity to invest in alternative asset categories, previously difficult and costly for the average individual to access. Because they are publicly traded, alt funds are SEC-registered and regulated, specifically by the Investment Company Act of 1940.

Example of Alternative Investments

Just being regulated does not mean that alt funds are safe investments. The SEC notes, “Many alternative mutual funds have limited performance histories.”

Also, although its diversified portfolio naturally mitigates the threat of loss, an alt fund is still subject to the inherent risks of its underlying assets. Indeed, the track record of ETFs that specialize in alternative assets has been mixed.

For example, as of January 2022, the SPDR Dow Jones Global Real Estate ETF had an annualized five-year return of 6.17%. In contrast, the SPDR S&P Oil & Gas Exploration & Production ETF posted a return of –6.40% for the same period.

What Are the Key Characteristics of Alternative Investments?

Alternative investments tend to have high fees and minimum investments, compared to retail-oriented mutual funds and ETFs. They also tend to have lower transaction costs, and it can be harder to get verifiable financial data for these assets. Alternative investments also tend to be less liquid than conventional securities, meaning that it may be difficult even to value some of the more unique vehicles because they are so thinly traded.

How Can Alternative Investments Be Useful to Investors?

Some investors seek out alternative investments because they have a low correlation with the stock and bond markets, meaning that they maintain their values in a market downturn. Also, hard assets such as gold, oil, and real property are effective hedges against inflation. For these reasons, many large institutions such as pension funds and family offices seek to diversify some of their holdings in alternative investment vehicles.

What Are the Regulatory Standards for Alternative Investments?

Regulations for alternative investments are less clear than they are for more traditional securities. Although alternative investment vehicles are regulated by the SEC, their securities do not have to be registered. As a result, most of these investment vehicles are only available to institutions or wealthy accredited investors.

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Anomaly: Definition and Types in Economics and Finance

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Anomaly: Definition and Types in Economics and Finance

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What Is an Anomaly?

In economics and finance, an anomaly is when the actual result under a given set of assumptions is different from the expected result predicted by a model. An anomaly provides evidence that a given assumption or model does not hold up in practice. The model can either be a relatively new or older model.

Key Takeaways

  • Anomalies are occurrences that deviate from the predictions of economic or financial models that undermine those models’ core assumptions.
  • In markets, patterns that contradict the efficient market hypothesis like calendar effects are prime examples of anomalies.
  • Most market anomalies are psychologically driven.
  • Anomalies, however, tend to quickly disappear once knowledge about them has been made public.

Understanding Anomalies

In finance, two common types of anomalies are market anomalies and pricing anomalies. Market anomalies are distortions in returns that contradict the efficient market hypothesis (EMH). Pricing anomalies are when something—for example, a stock—is priced differently than how a model predicts it will be priced.

Common market anomalies include the small-cap effect and the January effect. The small-cap effect refers to the small company effect, where smaller companies tend to outperform larger ones over time. The January effect refers to the tendency of stocks to return much more in the month of January than in others.

Anomalies also often occur with respect to asset pricing models, in particular, the capital asset pricing model (CAPM). Although the CAPM was derived by using innovative assumptions and theories, it often does a poor job of predicting stock returns. The numerous market anomalies that were observed after the formation of the CAPM helped form the basis for those wishing to disprove the model. Although the model may not hold up in empirical and practical tests, it still does hold some utility.

Anomalies tend to be few and far between. In fact, once anomalies become publicly known, they tend to quickly disappear as arbitragers seek out and eliminate any such opportunity from occurring again.

Types of Market Anomalies

In financial markets, any opportunity to earn excess profits undermines the assumptions of market efficiency, which states that prices already reflect all relevant information and so cannot be arbitraged.

January Effect

The January effect is a rather well-known anomaly. According to the January effect, stocks that underperformed in the fourth quarter of the prior year tend to outperform the markets in January. The reason for the January effect is so logical that it is almost hard to call it an anomaly. Investors will often look to jettison underperforming stocks late in the year so that they can use their losses to offset capital gains taxes (or to take the small deduction that the IRS allows if there is a net capital loss for the year). Many people call this event tax-loss harvesting.

As selling pressure is sometimes independent of the company’s actual fundamentals or valuation, this “tax selling” can push these stocks to levels where they become attractive to buyers in January.

Likewise, investors will often avoid buying underperforming stocks in the fourth quarter and wait until January to avoid getting caught up in the tax-loss selling. As a result, there is excess selling pressure before January and excess buying pressure after Jan. 1, leading to this effect.

September Effect

The September effect refers to historically weak stock market returns for the month of September. There is a statistical case for the September effect depending on the period analyzed, but much of the theory is anecdotal. It is generally believed that investors return from summer vacation in September ready to lock in gains as well as tax losses before the end of the year.

There is also a belief that individual investors liquidate stocks going into September to offset schooling costs for children. As with many other calendar effects, the September effect is considered a historical quirk in the data rather than an effect with any causal relationship. 

Days of the Week Anomalies

Efficient market supporters hate the “Days of the Week” anomaly because it not only appears to be true, but it also makes no sense. Research has shown that stocks tend to move more on Fridays than Mondays and that there is a bias toward positive market performance on Fridays. It is not a huge discrepancy, but it is a persistent one.

The Monday effect is a theory which states that returns on the stock market on Mondays will follow the prevailing trend from the previous Friday. Therefore, if the market was up on Friday, it should continue through the weekend and, come Monday, resume its rise. The Monday effect is also known as the “weekend effect.”

On a fundamental level, there is no particular reason that this should be true. Some psychological factors could be at work. Perhaps an end-of-week optimism permeates the market as traders and investors look forward to the weekend. Alternatively, perhaps the weekend gives investors a chance to catch up on their reading, stew and fret about the market, and develop pessimism going into Monday.

Superstitious Indicators

Aside from calendar anomalies, there are some non-market signals that some people believe will accurately indicate the direction of the market. Here is a short list of superstitious market indicators:

  • The Super Bowl Indicator: When a team from the old American Football League wins the game, the market will close lower for the year. When an old National Football League team wins, the market will end the year higher. Silly as it may seem, the Super Bowl indicator was correct almost three-quarters of the time over a 53-year period ending in 2021. However, the indicator has one limitation: It contains no allowance for an expansion-team victory!
  • The Hemline Indicator: The market rises and falls with the length of skirts. Sometimes this indicator is referred to as the “bare knees, bull market” theory. To its merit, the hemline indicator was accurate in 1987, when designers switched from miniskirts to floor-length skirts just before the market crashed. A similar change also took place in 1929, but many argue as to which came first, the crash or the hemline shifts.
  • The Aspirin Indicator: Stock prices and aspirin production are inversely related. This indicator suggests that when the market is rising, fewer people need aspirin to heal market-induced headaches. Lower aspirin sales should indicate a rising market.

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What Are Accruals? How Accrual Accounting Works, With Examples

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What Are Accruals? How Accrual Accounting Works, With Examples

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What Are Accruals?

Accruals are revenues earned or expenses incurred that impact a company’s net income on the income statement, although cash related to the transaction has not yet changed hands. Accruals also affect the balance sheet, as they involve non-cash assets and liabilities.

For example, if a company has performed a service for a customer, but has not yet received payment, the revenue from that service would be recorded as an accrual in the company’s financial statements. This ensures that the company’s financial statements accurately reflect its true financial position, even if it has not yet received payment for all of the services it has provided.

Accrual accounts include, among many others, accounts payable, accounts receivable, accrued tax liabilities, and accrued interest earned or payable.

Key Takeaways

  • Accruals are needed for any revenue earned or expense incurred, for which cash has not yet been exchanged.
  • Accruals improve the quality of information on financial statements by adding useful information about short-term credit extended to customers and upcoming liabilities owed to lenders.
  • Accruals and deferrals are the basis of the accrual method of accounting.
  • This is the preferred method of accounting according to GAAP.
  • Accruals are created by adjusting journal entries at the end of each accounting period.

Understanding Accruals

An accrual is a record of revenue or expenses that have been earned or incurred, but have not yet been recorded in the company’s financial statements. This can include things like unpaid invoices for services provided, or expenses that have been incurred but not yet paid. Accruals are important because they help to ensure that a company’s financial statements accurately reflect its true financial position, even if it has not yet received payment for all of the services it has provided or paid all of its bills.

In accrual-based accounting, revenue is recognized when it is earned, regardless of when the payment is received. This means that if a company provides a service to a customer in December, but does not receive payment until January of the following year, the revenue from that service would be recorded in December, when it was earned. Similarly, expenses are recorded when they are incurred, regardless of when they are paid. For example, if a company incurs expenses in December for a service that will be received in January, the expenses would be recorded in December, when they were incurred.

The Accrual Method of Accounting

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.

Accrual accounting is the preferred method according to generally accepted accounting principles (GAAP). The accrual method is widely considered to provide a more accurate and comprehensive view of a company’s financial position and performance than the cash basis of accounting, which only records transactions when cash is exchanged.

Recording Accruals on the Income Statement and Balance Sheet

To record accruals on the balance sheet, the company will need to make journal entries to reflect the revenues and expenses that have been earned or incurred, but not yet recorded. For example, if the company has provided a service to a customer but has not yet received payment, it would make a journal entry to record the revenue from that service as an accrual. This would involve debiting the “accounts receivable” account and crediting the “revenue” account on the income statement.

On the other hand, if the company has incurred expenses but has not yet paid them, it would make a journal entry to record the expenses as an accrual. This would involve debiting the “expenses” account on the income statement and crediting the “accounts payable” account.

Examples of Accruals

Let’s look at an example of a revenue accrual for a utility company.

Accounts Payable

An example of an accrued expense for accounts payable f could be the cost of electricity that the utility company has used to power its operations, but has not yet paid for. In this case, the utility company would make a journal entry to record the cost of the electricity as an accrued expense. This would involve debiting the “expense” account and crediting the “accounts payable” account. The effect of this journal entry would be to increase the utility company’s expenses on the income statement, and to increase its accounts payable on the balance sheet.

Another example of an expense accrual involves employee bonuses that were earned in 2019, but will not be paid until 2020. The 2019 financial statements need to reflect the bonus expense earned by employees in 2019 as well as the bonus liability the company plans to pay out. Therefore, prior to issuing the 2019 financial statements, an adjusting journal entry records this accrual with a debit to an expense account and a credit to a liability account. Once the payment has been made in the new year, the liability account will be decreased through a debit, and the cash account will be reduced through a credit.

Accounts Receivable

The utility company generated electricity that customers received in December. However, the utility company does not bill the electric customers until the following month when the meters have been read. To have the proper revenue figure for the year on the utility’s financial statements, the company needs to complete an adjusting journal entry to report the revenue that was earned in December.

It will additionally be reflected in the receivables account as of December 31, because the utility company has fulfilled its obligations to its customers in earning the revenue at that point. The adjusting journal entry for December would include a debit to accounts receivable and a credit to a revenue account. The following month, when the cash is received, the company would record a credit to decrease accounts receivable and a debit to increase cash.

Accrued Interest

Another expense accrual occurs for interest. For example, a company with a bond will accrue interest expense on its monthly financial statements, although interest on bonds is typically paid semi-annually. The interest expense recorded in an adjusting journal entry will be the amount that has accrued as of the financial statement date. A corresponding interest liability will be recorded on the balance sheet.

What Are the Purpose of Accruals?

The purpose of accruals is to ensure that a company’s financial statements accurately reflect its true financial position. This is important because financial statements are used by a wide range of stakeholders, including investors, creditors, and regulators, to evaluate the financial health and performance of a company. Without accruals, a company’s financial statements would only reflect the cash inflows and outflows, rather than the true state of its revenues, expenses, assets, and liabilities. By recognizing revenues and expenses when they are earned or incurred, rather than only when payment is received or made, accruals provide a more accurate picture of a company’s financial position.

What Are the Types of Accruals?

Accrued revenues refer to the recognition of revenues that have been earned, but not yet recorded in the company’s financial statements. For example, if a company provides a service to a customer in December, but does not receive payment until January of the following year, the revenue from that service would be recorded as an accrual in December, when it was earned.

Accrued expenses refer to the recognition of expenses that have been incurred, but not yet recorded in the company’s financial statements. For example, if a company incurs expenses in December for a service that will be received in January, the expenses would be recorded as an accrual in December, when they were incurred.

Accrued interest refers to the interest that has been earned on an investment or a loan, but has not yet been paid. For example, if a company has a savings account that earns interest, the interest that has been earned but not yet paid would be recorded as an accrual on the company’s financial statements.

Is an Accrual a Credit or a Debit?

Whether an accrual is a debit or a credit depends on the type of accrual and the effect it has on the company’s financial statements.

For accrued revenues, the journal entry would involve a credit to the revenue account and a debit to the accounts receivable account. This has the effect of increasing the company’s revenue and accounts receivable on its financial statements.

For accrued expenses, the journal entry would involve a debit to the expense account and a credit to the accounts payable account. This has the effect of increasing the company’s expenses and accounts payable on its financial statements.

What Is the Journal Entry for Accruals?

In general, the rules for recording accruals are the same as the rules for recording other transactions in double-entry accounting. The specific journal entries will depend on the individual circumstances of each transaction.

The Bottom Line

Accruals impact a company’s bottom line, although cash has not yet exchanged hands. The accrual method of accounting is the preferred method according to GAAP, and involves making adjustments for revenue that has been earned but is not yet recorded, and expenses that have been incurred but are not yet recorded, by making adjusting journal entries at the end of the accounting period. Accruals are important because they help to ensure that a company’s financial statements accurately reflect its actual financial position.

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