What are accruals and how are they treated in bookkeeping?
Accruals are a fundamental accounting concept that involves recognizing revenues and expenses in the financial statements before cash is received or paid. They are necessary to accurately match income and expenses to the period in which they are incurred, providing a more accurate picture of a company’s financial performance and position. Accruals are primarily used in accrual accounting, which is the standard method for recording financial transactions.
There are two main types of accruals:
- Accrued Revenue: This occurs when a company earns revenue but hasn’t yet received cash for it. The revenue is recorded as an accrued receivable on the balance sheet and recognized in the income statement. This is common when providing services on credit, where the payment is expected at a later date.
Example of accrued revenue: A consulting firm completes a project for a client in December but expects payment in January. The consulting firm would record the revenue as an accrued receivable in December to reflect that it earned the revenue in that period, even though the cash has not been received.
- Accrued Expenses: This happens when a company incurs expenses but hasn’t yet paid for them. The expenses are recorded as an accrued liability on the balance sheet and recognized in the income statement. This is typical with expenses such as wages, interest, or utilities, which are incurred in one accounting period but paid in the following period.
Example of accrued expenses: A company incurs employee salaries for the last week of December but pays them in the following month, January. The company would record the salary expenses as an accrued liability in December to reflect that it incurred those expenses in that period, even though the payment has not been made.
Treatment in Bookkeeping:
To record accruals in bookkeeping, you typically use adjusting entries. Adjusting entries are made at the end of an accounting period to ensure that revenues and expenses are properly matched to the period they belong to.
For accrued revenue: Debit: Accrued Receivable (Current Asset) Credit: Revenue (Income)
For accrued expenses: Debit: Expense (Income Statement Account) Credit: Accrued Liability (Current Liability)
At the start of the next accounting period, when the cash is received for accrued revenue or paid for accrued expenses, you would make another entry to reverse the accrual and reflect the actual cash transaction.
Accruals play a crucial role in accurately reflecting a company’s financial performance and financial position, especially when there is a time lag between when transactions are initiated and when the cash is received or paid. By using accrual accounting and recording accruals, businesses can provide more meaningful and transparent financial statements to stakeholders.