An accrual is the basis of the accrual principle of accounting that adjusts the revenues earned and expenses incurred by a company at the end of a period, when no cash has been exchanged. The transactions would not be recorded in the company’s books of accounts under the cash basis of accounting, since there’s been no inflow and outflow of cash.
Accruals directly impact the income statement and balance sheet of a company through the preparation of adjusting journal entries made at the end of each accounting period. Accrual accounting seeks to align revenues and expenses with the time period when they were incurred, rather than the time period of the actual cash flows associated with them.
Accruals adjust the revenues earned and expenses incurred by a company when no cash has been exchanged.
Accruals are important because they help a company to keep track of its financial position more accurately and systematically.
Accrued revenues are revenues that are recognized before the cash is received by the company. Accrued expenses are expenses that are recognized before the cash is given out by the company.
Accruals – Importance
Accruals are important because they provide information about the business activities undertaken by a company, such as recording the revenue earned by extending credit to clients. The information cannot be provided simply by recording cash transactions.
By recording accruals, a company can better understand and measure its business activities and keep track of its future cash flows. Additionally, a company will be able to record intangible assets, such as goodwill, which have no monetary value.
Accruals – Types
Accruals are often used as a common abbreviation for the terms accrued revenues and accrued expenses. However, the two terms have distinct characteristics in accounting and economics.
Accrued revenues are recorded as receivables on the balance sheet, and are unpaid proceeds from the delivery of a commodity that will be paid by cash at a later date. From an accounting perspective, when cash is received at a later date for goods and services billed to a customer, the receivables account is credited.
In simple terms, receivables are reduced while the cash amount is increased. When such transactions are incurred, they must take place systematically and should be verifiable.
Accrued Revenues – Example
An example of accrued revenues is rental income. A landlord sometimes may allow a tenant to rent the premises before obtaining the payment for it. The tenant will be able to use all the facilities of the premises until the end of the rental period. Then, at the end of the billing period, the tenant will be billed.
During the rental period, the landlord will incur all the expenses to maintain the premises. The landlord will need to wait until the end of the rental period to receive the rental income, despite incurring expenses related to the premises and acknowledge receiving the rental income at a future date. The rental income will be accrued for the period so that the expenses incurred are matched with the rent revenue earned.
Accrued expenses are recorded as liabilities, such as a pending obligation to pay for a commodity that will be paid by cash at a later date. Such transactions usually take place after receiving an invoice from a creditor.
An accrued expense does not qualify as a provision because it is uncertain. The accrual principle of accounting allows an accountant to record expenses incurred without the outflow of cash, and adjust it at a later date.
Accrued Expenses – Example
An example of accrued expenses is a salesperson earning a commission for a product sold at the instance it took place. The commission will be recognized by the company as an expense in the period it occurred, even though the salesperson will be paid the commission at a later date in the next accounting period.
The expenses will be recorded in the current income statement of the company, and the accrued expense for the commission will reflect on the company’s balance sheet for the delivery period, not when the commission was actually paid out to the salesperson.
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