What is accrual accounting?
Accrual accounting is an accounting[1] method that recognises and records financial transactions of a business when they occur, regardless of when expenses are paid, or revenue are received.
Accrual accounting adheres to an accounting principle, called the matching principle. The matching principle dictates that related revenues and expenses are recorded in the same accounting period such as a month, quarter, or financial year.
Conversely, cash accounting, the other accounting method, only records financial transactions when payments are made or received.
Accruals
Accruals and deferrals form the basis of the accrual accounting method. Deferrals, also referred to as deferral accounts, enable businesses to report expenses or revenues in a later accounting period in which goods or services actually were delivered or received.
What is an accrual?
Simply put, accruals refer to adjustments that must be made for expenses that have been incurred by a business but not yet been paid for or reported in its general ledger. Likewise, accruals pertain to revenues that have been earned but not yet been received or recorded in the business’s accounting system.
The accruals are recorded by utilising adjusting journal entries at the end of each accounting period, ensuring that the financial statements are reflecting the adjusted figures (accruals).
Types of accruals
In accounting, accruals can be categorised into two types, namely accrued revenues, also referred to as receivables, and accrued expenses, also called payables.
The double-entry system of accounting (bookkeeping) requires that every financial transaction must be recorded in a minimum of two accounts – the one entry as a debit and the other one as a credit. Put differently, the amounts entered as debits have to equal the amounts entered as credits.
Based on the double-entry accounting concept, the entry (debit) in an accrued expense account (an income statement line item) is counterbalanced by an entry (credit) in an accrued liability account (a balance sheet line item). Similarly, the credit in an accrued revenue account (eventually reflected in the income statement) equals the debit in an accrued asset account, such as accounts receivable (eventually reported in the balance sheet).
Hence, an adjusting journal entry to record an accrual will impact both the income sheet and the balance sheet of a business.
A double-entry journal can comprise more than one debit entry or more than one credit entry. However, the bottom line is that all the debits of the journal entry must equal all the credits of the same entry.
Accrued revenues
Accrued revenues refer to goods or services provided by a business to customers, but the payments have not been received yet. These accruals can include income or assets, including non-cash-based assets such as property, plant, or equipment.
Typically, construction companies, businesses engaged in long-term engineering projects, and companies or municipalities providing utilities (electricity, water) to communities, are examples of businesses that will have to record accrued revenues.
For example, construction firm XYZ agrees by contract that it will erect a building for company ABC over a period of 6 months for a construction fee of R600 000, which will be paid upon completion.
By using the accrual accounting system, firm XYZ has to acknowledge that it is generating revenue during the construction process, although the firm has not received any payments yet. Recording the accrued revenue, XYZ is enabled to track its financial position more accurately. Hence, the firm will record the accrued income on a monthly basis as the project develops.
Recording accrued revenues
Accrued revenue is recorded in a business’s accounting records by utilising adjusting journal entries.
When an accrued revenue is recorded for the first time, the amount is credited to a revenue account that will be recognised on the income statement. On the business’s balance sheet, an associated asset account, such as accounts receivable, will be debited.
When payment is received for the accrued revenue, the following entries are recorded:
- The asset account, accounts receivable, is credited with the amount received.
- The asset account, cash received, is debited with the same amount.
Hence, only the two balance sheet accounts mentioned above will be affected, while the amount for income received on the income statement will remain the same.
Conversely, when one business records accrued revenues, the other business will record the financial transaction as an accrued expense, which will be reflected as a liability on its balance sheet.
Accrued expenses
Accrued expenses refer to situations when a business acquires goods or services on credit and enters the liabilities in its general ledger accounts, acknowledging its obligations to its creditors.
Put differently, an accrued expense is an expense incurred but not yet paid.
Examples of accrued expenses are:
- Supplier accruals: This type of accrued expense arises when a business acquires goods or services from suppliers on credit with the intention to pay it at a future date.
- Interest expense accruals are expenses pertaining to monthly interest owed on debt but not paid yet.
- Accrued salaries refer to a business’s amount of liability that remains at the end of an accounting period for salaries that have been earned by employees by not yet been paid to them.
Recording accrued expenses
Similar to accrued revenues, adjusting journal entries are used by a business to record accrued expenses in its general ledger.
For instance, company BBB owes firm ZZZ R20 000 for repairs done to one of its vehicles during the final month of its financial year. The bill for the repairs is only received in the first month of the following financial year.
To comply with the accrual method of accounting company BBB will be required to record the following journal entries:
- The R20 000 is debited to a repair expense account, which will be reflected in the income statement for the particular financial year.
- Meantime, R20 000 will be credited to a liability account such as accrued expenses payable, which will appear on the balance sheet.
Contrarily, firm ZZZ will record R20 000 as a credit in an accrued revenue account and as a debit in an asset account such as accounts receivable.
[1] Refer to the article, ‘Accounting Explained for Dummies’, for a detailed explanation of accounting.
Top 4 Brokers
