How Does Accrual Accounting Work?
Understanding this type of accounting can positively impact your balance sheets and financial statements. Whether you’re a start-up or a moderately growing business, you’ll be required to handle your incurred expenses and revenues. Read on to learn how to use the accrual method of accounting.
What Is Accrual Accounting?
In accounting, this term refers to the revenue that the company earned but didn’t get paid for. Additionally, it refers to the expenses that a business incurred without paying off at the time of recording these.
In other words, you can think of this method as the practice of adjusting your debits and credits for financial clarity.
Businesses aren’t always instantly paid in cash for the revenue they earn, nor do they instantly clear off every debt they incur.
In an ideal situation where earned revenues are instantly paid for and all incurred expenses are immediately cleared, there’d be no accruals to account for.
However, since this is generally not the case, businesses must learn to account for unpaid revenues at the time of drafting a financial statement or a balance sheet.
Likewise, when a business incurs expenses and doesn’t immediately pay them off, these expenses have to be accrued.
In accrual accounting, the revenues and expenses are matched to the time when they’re incurred instead of the time when the actual cash flow rolls in.
The Different Accrual Accounting Categories
Businesses must account for these amounts by sorting them either under revenues/receivables or expenses/payables.
- Revenues: Accrued revenue refers to your business’s payables. This applies to either the assets or the income that your company is set to receive. Companies can accrue revenue by supplying services or goods on credit
- Expenses: Accrued expenses refer to your business’s receivables. When a company purchases on its line of credit, it acknowledges its obligation to the creditor by entering the purchase as a liability in its account ledger. This is commonly thought of as an expense that has been incurred but not yet paid
A company may have to account for one or all of the following expense accruals:
- Interest-expense: Refers to the interests accrued but hasn’t yet been paid off
- Suppliers: Refers to expenses related to those operations that are performed by a third-party
- Salary/wage: Refers to money owed to employees who work for a certain period without having received their due payment
How To Record Accruals
This method provides accountants with a formula that they can use to record and adjust the incurred revenues and expenses.
- When creating an accurate financial statement, these records have to be systematically adjusted in the monthly accounts
- They must also be verifiable to increase the statement’s reliability
- Following the double-entry principle in accounting, companies should also take note of making similar adjustments in their balance sheets and income statements
Accrual Accounting Examples
Following examples related to accrued revenue and accrued expenses will further simplify the concept.
Here’s an example of accrued revenue accounting:
- An electricity company files its revenue using this method
- When it supplies electricity to its customers, the meter reads the total consumption which counts as the electric company’s receivable
- The company will have to wait one month, and sometimes later, to receive this pending revenue
- Meanwhile, it must use its expenses to pay employees, operate machinery, and clear the overhead costs
- These are then listed under liabilities in the accounting ledger. Once the customer pays the utility bill, the receivables will decrease and cash increases
Here’s an example of accrued expense accounting:
- Let’s suppose a company XYZ insures its vehicles at $600 paid twice a year
- In theory, XYZ owes the insurance company an annual amount of $1,200 until the end of insurance tenure
- When accounting for this expense, the company won’t report $600 under payables twice in one year. This is done when accounting via the cash method. In accrual accounting, the company will list the amount as $100 for each month of the year. Doing this helps the company to match the expense with the month it’s incurred for
Accrual Compared To Cash Basis Accounting
There’s only a slight difference between accrual and cash basis accounting. In cash basis accounting, the transaction is recorded at the time it takes place.
With the accrual basis of accounting, the transactions are reported by matching them with the period for which they’re incurred.
Companies can use any of the methods to position its financial standings at the end of a term.
Read more about: Cash Basis Accounting Vs. Accrual Accounting
Systematic and accurate reporting of your accounts involves an understanding of the expenses and revenues not only when they’re debited or credited but also when they’re incurred.
This allows businesses to keep track of expense management and revenue expectations, both of which are the key to smooth cash-flows.