What are accruals (short answer)
– Accruals are amounts for revenues earned or expenses incurred that have not yet been settled in cash. They ensure that income and costs are shown in the period when the underlying economic activity occurred, not necessarily when money moves.
Why accruals matter
– They align the income statement and balance sheet with the timing of business activity. Without accruals, financial results can be shifted across reporting periods (for example, revenue recorded only when cash arrives), which masks the true performance of a period.
Key definitions
– Accrual accounting: an accounting method that recognizes revenue when it is earned and expenses when they are incurred, regardless of cash flows.
– Cash accounting: a method that recognizes transactions only when cash is received or paid.
– Accrued expense (accrued liability): a cost that a company has incurred but not yet paid (e.g., utilities used during the month but billed later).
– Accrued revenue (accounts receivable): revenue earned but not yet collected in cash (e.g., services performed on credit).
– Prepaid expense: cash paid in advance for goods or services to be consumed later; recorded as an asset and expensed over time (e.g., annual insurance premium).
– Deferred (or unearned) revenue: cash received before delivering goods or services; recorded as a liability until the obligation is satisfied (e.g., advance subscription payments).
Accrual accounting vs. cash accounting — short comparison
– Accrual: records income when earned and expenses when incurred. Required for most publicly reported financial statements under U.S. GAAP and IFRS.
– Cash: records only when cash changes hands. Simpler, often used by small businesses and for internal cash management.
How accruals are recorded (practical steps)
1. Identify the economic event that occurred during the reporting period (service rendered, goods delivered, expense consumed).
2. Determine whether cash has been received or paid. If not, an accrual or deferral is needed.
3. Measure the amount to record (invoice, meter reading, contract terms).
4. Make an adjusting journal entry at period end:
– Accrued revenue: debit Accounts Receivable (asset), credit Revenue (income).
– Accrued expense: debit Expense (income statement), credit Accounts Payable or Accrued Liabilities (liability).
– Prepaid expense: debit Prepaid Asset, credit Cash when paid; then expense gradually over time.
– Deferred revenue: debit Cash when received, credit Deferred Revenue (liability); then recognize revenue as earned.
5. Reverse or clear the accrual when the cash transaction occurs in a subsequent period (if appropriate).
Journal-entry examples — small numeric illustrations
1) Accrued expense (utilities)
– Situation: Company used $1,200 of electricity in December; bill arrives and is paid in January.
– December adjusting entry (to recognize expense in December):
– Debit Utilities Expense $1,200
– Credit Accrued Liabilities (or Accounts Payable) $1,200
– Effect: Expense shown in December; liability appears on the balance sheet.
– January when bill is paid:
– Debit Accrued Liabilities $1,200
– Credit Cash $1,200
2) Accrued revenue (services on credit)
– Situation: Company provides $5,000 of consulting on Dec 20; customer pays in January.
– December entry:
– Debit Accounts Receivable $5,000
– Credit Service Revenue $5,000
– January when cash received:
– Debit Cash $5,000
– Credit Accounts Receivable $5,000
3) Deferred revenue (subscription)
– Situation: Customer pays $1,200 on Jan 1 for a 12‑month subscription starting Jan 1.
– Jan 1 entry:
– Debit Cash $1,200
– Credit Deferred Revenue $1,200
– Monthly recognition (each month):
– Debit Deferred Revenue $100
– Credit Subscription Revenue $100
Common examples of accruals
– Utilities billed after consumption.
– Interest accrued between coupon payments on bonds.
– Wages earned by employees at period end but paid in the next payroll.
– Taxes owed based on earnings in the period but payable later.
– Goods shipped on credit (accounts receivable).
– Advance customer payments for services to be provided later (deferred revenue).
Checklist for handling accruals at period end
– Have I identified goods/services earned or costs consumed during the period?
– Is there any cash still outstanding related to those items?
– Have I measured the amount reliably (invoice, contract, meter, payroll)?
– Have I recorded the appropriate journal entry (debit/credit)?
– Will the accrual be reversed or settled in the next period — and does the accounting system support reversing entries?
– Are material accruals disclosed in notes where required?
Assumptions and simplifying notes
– Examples above assume no taxes, discounts, or penalties and that amounts are measured with reasonable certainty.
– In practice, estimates (for example, for accrued bonuses or warranty costs) may be required and need periodic reassessment.
– External financial reporting typically follows local accounting standards (U.S. GAAP or IFRS), which mandate accrual basis for prepared financial statements.
Where to read more (reputable sources)
– Investopedia — Accruals: https://www.investopedia.com/terms/a/accruals.asp
– Financial Accounting Standards Board (FASB): https://www.fasb.org
– IFRS Foundation — International Financial Reporting Standards: https://www.ifrs.org
– U.S. Securities and Exchange Commission — investor publications and resources: https://www.sec.gov
Educational disclaimer
This explanation is for educational purposes only. It does not constitute personalized financial, tax, or accounting advice. For specific situations, consult a qualified accountant, tax advisor, or financial professional.