What Is Accrue?

To accrue means to accumulate over time—most commonly used when referring to the interest, income, or expenses of an individual or business. Interest in a savings account, for example, accrues over time, such that the total amount in that account grows. The term accrue is often related to accrual accounting, which has become the standard accounting practice for most companies.

Key Takeaways

• Accrue is the accumulation of interest, income, or expenses over time—interest in a savings account is a popular example.
• When something financial accrues, it essentially builds up to be paid or received in a future period.
• Accrue most often refers to the concepts of accrual accounting, where there are accrued revenue sand accrued expenses.
• Accrued revenue is when a company has sold a product or service but has yet to be paid for it.
• Accrued expenses are expenses that are recognized before being paid, such as certain interest expenses or salaries.

How Accrue Works

When something financial accrues, it essentially builds up to be paid or received in a future period. Both assets and liabilities can accrue over time. The term “accrue,” when related to finance, is synonymous with an “accrual” under the accounting method outlined by Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).

An accrual is an accounting adjustment used to track and record revenues that have been earned but not received, or expenses that have been incurred but not paid. Think of accrued entries as the opposite of unearned entries—with accrued entries, the corresponding financial event has already taken place but payment has not been made or received.

Accepted and mandatory accruals are decided by the Financial Accounting Standards Board (FASB), which controls interpretations of GAAP. Accruals can include accounts payable, accounts receivable, goodwill, future tax liability, and future interest expense. 

Special Considerations

The accrual accounting procedure measures the performance and position of a company by recognizing economic events regardless of when cash transactions occur, giving a better picture of the company’s financial health and causing asset or liability adjustments to “build up” over time.

This is in contrast to the cash method of accounting where revenues and expenses are recorded when the funds are actually paid or received, leaving out revenue based on credit and future liabilities. Cash-based accounting does not require adjustments.

While some very small or new businesses use cash accounting, companies normally prefer the accrual accounting method. Accrual accounting gives a far better picture of a company’s financial situation than cost accounting because it records not only the company’s current finances but also future transactions.

If a company sold $100 worth of product on credit in January, for example, it would want to record that $100 in January under the accrual accounting method rather than wait until the cash is actually received, which may take months or may even become a bad debt.

Types of Accrues

 All accruals fall into one of two categories—either revenue or expense accrual.

Accrued Revenue

Revenue accruals represent income or assets (including non-cash-based ones) yet to be received. These accruals occur when a good or service has been sold by a company, but the payment for it has not been made by the customer. Companies with large amounts of credit card transactions usually have high levels of accounts receivable and high levels of accrued revenue.

Assume that Company ABC hires Consulting Firm XYZ to help on a project that is estimated to take three months to complete. The fee for this job is $150,000, to be paid upon completion. While ABC owes XYZ $50,000 after each monthly milestone, the total fee accrues over the duration of the project instead of being paid in installments.

Accrued Expense

Whenever a business recognizes an expense before it is actually paid, it can make an accrual entry in its general ledger. The expense may also be listed as accrued in the balance sheet and charged against income in the income statement. Common types of accrued expense include:

• Interest expense accruals—these occur when a owes monthly interest on debt prior to receiving the monthly invoice.
• Supplier accruals—these happen if a company receives a good or service from a supplier on credit and plans to pay the supplier at a later date.
• Wage or salary accruals—these expenses happen when a company pays employees prior to the end of the month for a full month of work.

Interest, taxes and other payments sometimes need to be put into accrued entries whenever unpaid obligations should be recognized in the financial statements. Otherwise, the operating expenses for a certain period might be understated, which would result in net income being overstated.

Salaries are accrued whenever a workweek does not neatly correspond with monthly financial reports and payroll. For example, a payroll date may fall on Jan. 28. If employees have to work on January 29, 30, or 31, those workdays still count toward the January operating expenses. Current payroll has not yet accounted for those salary expenses, so an accrued salary account is used.

There are different rationales for accruing specific expenses. The general purpose of an accrual account is to match expenses with the accounting period during which they were incurred. Accrued expenses are also effective in predicting the amount of expenses the company can expect to see in the future.

What Is an Audit?

The term audit usually refers to a financial statement audit. A financial audit is an objective examination and evaluation of the financial statements of an organization to make sure that the financial records are a fair and accurate representation of the transactions they claim to represent. The audit can be conducted internally by employees of the organization or externally by an outside Certified Public Accountant (CPA) firm.

Key Takeaways

• There are three main types of audits: external audits, internal audits, and Internal Revenue Service (IRS) audits.
• External audits are commonly performed by Certified Public Accounting (CPA) firms and result in an auditor’s opinion which is included in the audit report.
• An unqualified, or clean, audit opinion means that the auditor has not identified any material misstatement as a result of his or her review of the financial statements.
• External audits can include a review of both financial statements and a company’s internal controls.
• Internal audits serve as a managerial tool to make improvements to processes and internal controls.

Understanding Audits

Almost all companies receive a yearly audit of their financial statements, such as the income statement, balance sheet, and cash flow statement. Lenders often require the results of an external audit annually as part of their debt covenants. For some companies, audits are a legal requirement due to the compelling incentives to intentionally misstate financial information in an attempt to commit fraud. As a result of the Sarbanes-Oxley Act (SOX) of 2002, publicly traded companies must also receive an evaluation of the effectiveness of their internal controls.

Standards for external audits performed in the United States, called the generally accepted auditing standards (GAAS), are set out by Auditing Standards Board (ASB) of the American Institute of Certified Public Accountants (AICPA). Additional rules for the audits of publicly traded companies are made by the Public Company Accounting Oversight Board (PCAOB), which was established as a result of SOX in 2002. A separate set of international standards, called the International Standards on Auditing (ISA), were set up by the International Auditing and Assurance Standards Board (IAASB).

Types of Audits

External Audits

Audits performed by outside parties can be extremely helpful in removing any bias in reviewing the state of a company’s financials. Financial audits seek to identify if there are any material misstatements in the financial statements. An unqualified, or clean, auditor’s opinion provides financial statement users with confidence that the financials are both accurate and complete. External audits, therefore, allow stakeholders to make better, more informed decisions related to the company being audited.

External auditors follow a set of standards different from that of the company or organization hiring them to do the work. The biggest difference between an internal and external audit is the concept of independence of the external auditor. When audits are performed by third parties, the resulting auditor’s opinion expressed on items being audited (a company’s financials, internal controls, or a system) can be candid and honest without it affecting daily work relationships within the company.

Internal Audits

Internal auditors are employed by the company or organization for whom they are performing an audit, and the resulting audit report is given directly to management and the board of directors. Consultant auditors, while not employed internally, use the standards of the company they are auditing as opposed to a separate set of standards. These types of auditors are used when an organization doesn’t have the in-house resources to audit certain parts of their own operations.

The results of the internal audit are used to make managerial changes and improvements to internal controls. The purpose of an internal audit is to ensure compliance with laws and regulations and to help maintain accurate and timely financial reporting and data collection. It also provides a benefit to management by identifying flaws in internal control or financial reporting prior to its review by external auditors.

Internal Revenue Service (IRS) Audits

The Internal Revenue Service (IRS) also routinely performs audits to verify the accuracy of a taxpayer’s return and specific transactions. When the IRS audits a person or company, it usually carries a negative connotation and is seen as evidence of some type of wrongdoing by the taxpayer. However, being selected for an audit is not necessarily indicative of any wrongdoing.

IRS audit selection is usually made by random statistical formulas that analyze a taxpayer’s return and compare it to similar returns. A taxpayer may also be selected for an audit if they have any dealings with another person or company who was found to have tax errors on their audit.

There are three possible IRS audit outcomes available: no change to the tax return, a change that is accepted by the taxpayer, or a change that the taxpayer disagrees with. If the change is accepted, the taxpayer may owe additional taxes or penalties. If the taxpayer disagrees, there is a process to follow that may include mediation or an appeal.

What Is a 401(k) Plan?

A 401(k) plan is a retirement savings plan offered by many American employers that has tax advantages for the saver. It is named after a section of the U.S. Internal Revenue Code (IRC).

The employee who signs up for a 401(k) agrees to have a percentage of each paycheck paid directly into an investment account. The employer may match part or all of that contribution. The employee gets to choose among a number of investment options, usually mutual funds.

How 401(k) Plans Work

The 401(k) plan was designed by the United States Congress to encourage Americans to save for retirement. Among the benefits they offer is tax savings.

There are two main options, each with distinct tax advantages.

Traditional 401(k)

With a traditional 401(k), employee contributions are deducted from gross income. This means the money comes from your paycheck before income taxes have been deducted. As a result, your taxable income is reduced by the total amount of contributions for the year and can be reported as a tax deduction for that tax year. No taxes are due on either the money contributed or the investment earnings until you withdraw the money, usually in retirement.

Roth 401(k)

With a Roth 401(k), contributions are deducted from your after-tax income. This means contributions come from your pay after income taxes have been deducted. As a result, there is no tax deduction in the year of the contribution. When you withdraw the money during retirement, though, you don’t have to pay any additional taxes on your contribution or on the investment earnings.

However, not all employers offer the option of a Roth account. If the Roth is offered, you can choose between a traditional and Roth 401(k). Or you can contribute to both up to the annual contribution limit.

Contributing to a 401(k) Plan

A 401(k) is a defined contribution plan. The employee and employer can make contributions to the account up to the dollar limits set by the Internal Revenue Service (IRS).

A defined contribution plan is an alternative to the traditional pension, known as a defined-benefit plan. With a pension, the employer is committed to providing a specific amount of money to the employee for life during retirement.

In recent decades, 401(k) plans have become more common, and traditional pensions have become rare as employers have shifted the responsibility and risk of saving for retirement to their employees.

Employees also are responsible for choosing the specific investments within their 401(k) accounts from a selection that their employer offers. Those offerings typically include an assortment of stock and bond mutual funds and target-date funds designed to reduce the risk of investment losses as the employee approaches retirement.

They may also include guaranteed investment contracts (GICs) issued by insurance companies and sometimes the employer’s own stock.

Contribution Limits

The maximum amount that an employee or employer can contribute to a 401(k) plan is adjusted periodically to account for inflation, which is a metric that measures rising prices in an economy.

For 2022, the annual limit on employee contributions was $20,500 per year for workers under age 50. However, those aged 50 and over could make a $6,500 catch-up contribution.

For 2023, the annual limit on employee contributions is $22,500 per year for workers under age 50. If you are age 50 or over, you can make an additional $7,500 catch-up contribution.

If your employer also contributes or if you elect to make additional, non-deductible after-tax contributions to your traditional 401(k) account, there is a total employee-and-employer contribution amount for the year:

2022

• For workers under 50 years old, the total employee-employer contributions could not exceed $61,000 per year.
• If the catch-up contribution for those 50 and over was included, the limit was $67,500.

2023

• For workers under 50 years old, the total employee-employer contributions cannot exceed $66,000 per year.
• If the catch-up contribution for those 50 and over is included, the limit is $73,500.

Employer Matching

Employers who match employee contributions use various formulas to calculate that match.

For instance, an employer might match 50 cents for every dollar that the employee contributes, up to a certain percentage of salary.

Financial advisors often recommend that employees contribute at least enough money to their 401(k) plans to get the full employer match.

Contributing to Both a Traditional and a Roth 401(k)

If their employer offers both types of 401(k) plans, an employee can split their contributions, putting some money into a traditional 401(k) and some into a Roth 401(k).

However, their total contribution to the two types of accounts can’t exceed the limit for one account (such as $20,500 for those under age 50 in 2022 or $22,500 in 2023).

How Does a 401(k) Earn Money?

Your contributions to your 401(k) account are invested according to the choices you make from the selection your employer offers. As noted above, these options typically include an assortment of stock and bond mutual funds and target-date funds designed to reduce the risk of investment losses as you get closer to retirement.

How much you contribute each year, whether or not your company matches your contributions, your investments and their returns, plus the number of years you have until retirement all contribute to how quickly and how much your money will grow.

Provided you don’t remove funds from your account, you don’t have to pay taxes on investment gains, interest, or dividends until you withdraw money from the account after retirement (unless you have a Roth 401(k), in which case you don’t have to pay taxes on qualified withdrawals when you retire).

What’s more, if you open a 401(k) when you are young, it has the potential to earn more money for you, thanks to the power of compounding. The benefit of compounding is that returns generated by savings can be reinvested back into the account and begin generating returns of their own.

Over a period of many years, the compounded earnings on your 401(k) account can actually be larger than the contributions you have made to the account. In this way, as you keep contributing to your 401(k), it has the potential to grow into a sizable chunk of money over time.

Taking Withdrawals From a 401(k)

Once money goes into a 401(k), it is difficult to withdraw it without paying taxes on the withdrawal amounts.

“Make sure that you still save enough on the outside for emergencies and expenses you may have before retirement,” says Dan Stewart, CFA®, president of Revere Asset Management Inc., in Dallas. “Do not put all of your savings into your 401(k) where you cannot easily access it, if necessary.”

The earnings in a 401(k) account are tax deferred in the case of traditional 401(k)s and tax free in the case of Roths. When the traditional 401(k) owner makes withdrawals, that money (which has never been taxed) will be taxed as ordinary income. Roth account owners have already paid income tax on the money they contributed to the plan and will owe no tax on their withdrawals as long as they satisfy certain requirements.

Both traditional and Roth 401(k) owners must be at least age 59½—or meet other criteria spelled out by the IRS, such as being totally and permanently disabled—when they start to make withdrawals to avoid a penalty.

This penalty is usually an additional 10% early distribution tax on top of any other tax they owe.

Some employers allow employees to take out a loan against their contributions to a 401(k) plan. The employee is essentially borrowing from themselves. If you take out a 401(k) loan and leave the job before the loan is repaid, you’ll have to repay it in a lump sum or face the 10% penalty for an early withdrawal.

Required Minimum Distributions (RMDs)

Traditional 401(k) account holders are subject to required minimum distributions (RMDs) after reaching a certain age. (Withdrawals are often referred to as distributions in IRS parlance.)

Beginning on January 1, 2023, account owners who have retired must start taking RMDs from their 401(k) plans starting at age 73. This size of the RMD is calculated is based on your life expectancy at the time. Prior to 2020, the RMD age was 70½ years old. Before 2023, the RMD age was 72. It was updated to age 73 in the omnibus spending bill H.R. 2617 in 2022.

Note that distributions from a traditional 401(k) are taxable. Qualified withdrawals from a Roth 401(k) are not.

Traditional 401(k) vs. Roth 401(k)

When 401(k) plans became available in 1978, companies and their employees had just one choice: the traditional 401(k). Then in 2006, Roth 401(k)s arrived. Roths are named for former U.S. Senator William Roth of Delaware, the primary sponsor of the 1997 legislation that made the Roth IRA possible.

While Roth 401(k)s were a little slow to catch on, many employers now offer them. So the first decision employees often have to make is choosing between a Roth and a traditional (401(k).

As a general rule, employees who expect to be in a lower marginal tax bracket after they retire might want to opt for a traditional 401(k) and take advantage of the immediate tax break.

On the other hand, employees who expect to be in a higher bracket after retiring might opt for the Roth so that they can avoid taxes on their savings later. Also important—especially if the Roth has years to grow—is that, since there is no tax on withdrawals, all the money that the contributions earn over decades of being in the account is tax free.

As a practical matter, the Roth reduces your immediate spending power more than a traditional 401(k) plan. That matters if your budget is tight.

Since no one can predict what tax rates will be decades from now, neither type of 401(k) is a sure thing. For that reason, many financial advisors suggest that people hedge their bets, putting some of their money into each.

When You Leave Your Job

When you leave a company where you’ve been employed and you have a 401(k) plan, you generally have four options:

1. Withdraw the Money

Withdrawing the money is usually a bad idea unless you urgently need the cash. The money will be taxable in the year it’s withdrawn. You will be hit with the additional 10% early distribution tax unless you are over 59½, permanently disabled, or meet the other IRS criteria for an exception to the rule.

In the case of a Roth 401(k), you can withdraw your contributions (but not any profits) tax free and without penalty at any time as long as you have had the account for at least five years. Remember, however, that you’re still diminishing your retirement savings, which you may regret later.

2. Roll Your 401(k) into an IRA

By moving the money into an IRA at a brokerage firm, a mutual fund company, or a bank, you can avoid immediate taxes and maintain the account’s tax-advantaged status. What’s more, you will be able to select from among a wider range of investment choices than with your employer’s plan.

The IRS has relatively strict rules on rollovers and how they need to be accomplished, and running afoul of them is costly. Typically, the financial institution that is in line to receive the money will be more than happy to help with the process and prevent any missteps.

3. Leave Your 401(k) With the Old Employer

In many cases, employers will permit a departing employee to keep a 401(k) account in their old plan indefinitely, though the employee can’t make any further contributions to it. This generally applies to accounts worth at least $5,000. In the case of smaller accounts, the employer may give the employee no choice but to move the money elsewhere.

Leaving 401(k) money where it is can make sense if the old employer’s plan is well managed and you are satisfied with the investment choices it offers. The danger is that employees who change jobs over the course of their careers can leave a trail of old 401(k) plans and may forget about one or more of them. Their heirs might also be unaware of the existence of the accounts.

4. Move Your 401(k) to a New Employer

You can usually move your 401(k) balance to your new employer’s plan. As with an IRA rollover, this maintains the account’s tax-deferred status and avoids immediate taxes.

It could be a wise move if you aren’t comfortable with making the investment decisions involved in managing a rollover IRA and would rather leave some of that work to the new plan’s administrator.

The Bottom Line

A 401(k) plan is a workplace retirement plan that lets you make annual contributions up to a certain limit and invest that money for the benefit of your later years once your working days are done.

401(k) plans come in two types: a traditional or Roth. The traditional 401(k) involves pre-tax contributions that give you a tax break when you make them and reduce your taxable income. However, you pay ordinary income tax on your withdrawals. The Roth 401(k) involves after-tax contributions and no upfront tax break, but you’ll pay no taxes on your withdrawals in retirement. Both accounts allow employer contributions that can increase your savings.