What Are Accruals? How Accrual Accounting Works, With Examples

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.

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.

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.

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.