Accruals

Accruals: Definition and Overview

Accruals are revenues earned or expenses incurred for which cash has not yet been received or paid. Under accrual accounting—required by GAAP and IFRS for most larger businesses—these transactions are recorded when they occur, not when cash changes hands. This approach ensures financial statements reflect the economic activity of a reporting period.

Why Accruals Matter

• They align income and expenses with the periods in which they are earned or incurred (matching principle).
• Without accruals, financial statements could misrepresent profitability and performance, especially when payments are delayed or received in advance.
• Accrual accounting provides a more complete and accurate view of a company’s financial position than cash-basis accounting.

Accrual Accounting vs. Cash Accounting

• Cash accounting: Record revenue and expenses only when cash is received or paid. Simpler and often used by small businesses.
• Accrual accounting: Record revenue when earned and expenses when incurred, regardless of cash flow timing. More complex but gives a truer picture of ongoing operations and obligations.

Example consequence: A company that performs work in December but is paid in January will show the revenue in December under accrual accounting, but in January under cash accounting—potentially distorting period-to-period comparisons.

Recording Accruals (Double-Entry Basics)

Accruals are recorded using double-entry accounting. Typical journal entries:

• Accrued revenue (earned but not yet received):
• Debit Accounts Receivable (asset)
• Credit Revenue (income)
• Accrued expense (incurred but not yet paid):
• Debit Expense (income statement)
• Credit Accounts Payable (liability)
• Prepaid expense (paid in advance):
• When paid: Debit Prepaid Expense (asset), Credit Cash
• As consumed: Debit Expense, Credit Prepaid Expense
• Deferred (unearned) revenue (cash received before earning):
• When received: Debit Cash, Credit Deferred Revenue (liability)
• When earned: Debit Deferred Revenue, Credit Revenue

Types of Accruals

1. Accrued Expenses (Accrued Liabilities)
2. Expenses incurred during a period but unpaid at period end (e.g., utilities, wages, interest, taxes).
3. Prepaid Expenses
4. Payments made in advance for goods or services to be consumed later (e.g., insurance premiums, retainers). Initially recorded as assets and expensed over time.
5. Accrued Revenue
6. Revenue earned before cash is received (e.g., sales on credit, services performed with payment due later).
7. Deferred (Unearned) Revenue
8. Cash received before goods or services are delivered (e.g., subscriptions, advance payments). Recorded as a liability until the revenue is earned.

Common Examples

• Utilities: Company uses electricity in one period but pays the bill later—record an accrued expense; the utility records accrued revenue.
• Wages and bonuses: Payroll earned by employees in one period but paid in the next is recorded as an accrued expense.
• Interest and taxes: Often recognized in the period incurred and settled later.
• Subscriptions and advance deposits: Cash received up front is held as deferred revenue until services are provided.

Key Takeaways

• Accruals ensure revenues and expenses are recognized in the periods they actually relate to, improving accuracy of financial reporting.
• Accrual accounting requires consistent use of journal entries and adherence to the matching principle.
• The four main accrual categories—accrued expenses, prepaid expenses, accrued revenue, and deferred revenue—affect both the income statement and balance sheet.
• Most larger companies and financial reporting frameworks (GAAP/IFRS) prefer accrual accounting because it better reflects economic reality.