Accruals are revenues acquired or expenses incurred that impact the net income of the company. The accrual method helps to present the real picture of the inflow and outflow of cash as well as credit in the company. Before accruals were introduced, cash was the only prominent form of recording transactions in a company.
Accruals are extensively used in accounting. It is presented in the income statement, even when the cash is not yet in the hands of the company. Accruals affect the balance sheet since they also include non-cash liabilities and assets. This account also substitutes different accounts like accounts receivable, accounts payable, accrued tax liabilities and accrued interest.
Deferrals and accruals are both used widely in the accrual basis of the account, which is also recommended by GAAP (Generally Accepted Accounting Principle). The accrual method helps to present the real picture of the inflow and outflow of cash as well as credit in the company. These accruals are recorded through adjustments in the journal ledger when the fiscal period ends. Hence, the financial statements also include these amounts.
Importance of using accruals
Using accruals helps provide quality information through the financial statements. Before accruals were introduced, cash was the only prominent form of recording transactions in a company. But cash only includes the transactions that involve exchanges of cash and eliminates the other business activities that were done on a non-cash basis, like revenue on credit that was provided to the customer or liabilities of the future.
Hence, accruals help to figure out what short-term debt is owed to the suppliers and how much revenue is tentative for the future. It also helps to add fictitious assets to the balance sheet and other statements like goodwill.
In the case of the double-entry system, accrued liability is used to offset accrual expenses. For accrued revenue, an accrued asset is used which can also be seen in the balance sheet. Hence, adjustment entries for accruals affect the income statements and balance sheets as well.
Accruals examples
For example, in an electric utility company, electricity creation was done and rendered to the customers during the month of December. However, the charges for the service provided are not taken from the customers until the meter reading is done the following month. Hence, to show the correct financial position of the company at the end of the fiscal year the company will show the revenue accrued during the month of December through accrual entries.
Moreover, this entry will also come up in the receivable account on December 21, as the company earned revenue by providing electricity in December. Hence, in December, the adjustment entry will contain accounts receivable as debit and credited revenue accounts. And when the cash is received from the customer after the month of December, another entry will be made which will have a credit entry that reduces the accounts receivable account and debit which increases the cash.
To understand expense accrual, we will take into account the payment of bonuses earned in 2019 and given out in 2020. In the 2019 financial statement, the company needs to show the bonuses that were earned by the employees as a liability since it is what the company owes to the employees. Hence, an adjusting journal entry will be made with expense account debit and liability account credit. Once this payment is obliged, another entry will be made which will credit the liability account and decrease the cash through credit.
Interest can also be treated as accruals. For instance, a company that has bonds will accrue interest in the monthly financial statement, even when the interest is calculated quarterly or semi-annually. The interest will be recorded in the journal entry and financial statement too. And a liability will be added to the balance sheet with regards to that.
