Managing money is more than just tracking what comes in and goes out. For business owners and financial enthusiasts alike, understanding accruals is a crucial part of painting an accurate picture of financial health.
In this guide, we’re breaking down the concept of accruals, why they matter, and how they’re used in business accounting. Whether you’re a small business owner, an accounting student, a finance pro, or just a curious learner, this guide will leave you confident in your understanding of accruals.
What Are Accruals
Accruals are accounting entries used to record revenues and expenses when they are incurred, regardless of when cash is received or paid. They form the backbone of accrual accounting and help provide a more accurate reflection of a company’s financial position.
Why Are Accruals Important
By recording financial events as they happen (rather than just after cash changes hands), accruals ensure that businesses have a clear view of their earnings and obligations. This not only helps with better decision-making but also aligns with accounting principles like the matching principle and revenue recognition principle.
Understanding Accrual Accounting
Accrual accounting is one of the two primary accounting methods, with the other being cash accounting. Here’s how they compare.
Accrual Accounting vs. Cash Accounting
- Accrual Accounting records revenue and expenses when they’re earned or incurred, even if payment hasn’t been made or received.
- Cash Accounting records revenue and expenses only when cash is received or paid.
For example, if you complete a service in May but get paid in June, accrual accounting would reflect the income in May. On the other hand, cash accounting would log it in June.
Most businesses, especially those that need external financing or adhere to regulatory requirements, use accrual accounting because it provides a clearer picture of financial health.
Types of Accruals
Accruals fall into two main categories, each playing an important role in accounting.
Accrued Expenses
Definition
Accrued expenses are costs that a business has incurred but hasn’t paid for yet.
Examples
- Salaries and wages earned by employees but not yet paid.
- Interest on loans that’s been incurred but not paid by the end of the accounting period.
- Utility bills for services consumed but not yet invoiced.
Accrued Revenues
Definition
Accrued revenues refer to income earned but not yet billed or received in cash.
Examples
- A consultancy firm providing services in December but issuing invoices in January.
- Interest income earned but not yet credited to a bank account.
How to Record Accruals
Properly recording accruals ensures the accuracy of financial statements. Here’s how it’s done with journal entries.
Journal Entry for Accrued Expenses
When recording an accrued expense, increase the expense account and create a liability.
Example for Accrued Salaries
- Entry at Month-End
- Debit (Increase) Salaries Expense $5,000
- Credit (Increase) Salaries Payable $5,000
- Entry When Paid
- Debit (Decrease) Salaries Payable $5,000
- Credit (Decrease) Cash $5,000
Journal Entry for Accrued Revenues
When recording accrued revenue, increase the revenue account and create a receivable.
Example for Accrued Service Revenue
- Entry at Month-End
- Debit (Increase) Accounts Receivable $3,000
- Credit (Increase) Service Revenue $3,000
- Entry When Received
- Debit (Decrease) Cash $3,000
- Credit (Decrease) Accounts Receivable $3,000
The Importance of Accurate Accruals
Accurate accruals are vital for many reasons.
- Financial Statement Accuracy
Misstated accruals can give a distorted view of a company’s financial position, which may lead to regulatory or reputational risks.
- Decision-Making
Accurate accruals enable businesses to forecast cash flows, manage budgets, and make informed decisions.
- Compliance
Adhering to accounting standards ensures compliance with regulations and enhances trust among investors and stakeholders.
Accruals vs. Deferrals
While accruals account for income and expenses already earned or incurred, deferrals do the opposite. They deal with cash received or paid in advance for goods or services that will be delivered in the future.
Examples of Deferrals
- Prepaid Expenses (e.g., paying rent for the upcoming year).
- Unearned Revenue (e.g., receiving a deposit for a project not yet started).
Real-World Examples of Accruals
Here are common scenarios where accruals come into play across industries.
- Hospitality
Hotels recognize revenue for stays completed by year-end but haven’t yet received payment for.
- Tech
Software companies accrue revenue for licenses delivered or services rendered, even if the invoices are sent later.
- Manufacturing
Factories record utility expenses incurred during production but billed only in the next month.
Tips for Managing Accruals
Here are best practices to stay on top of accruals.
- Stay Organized
Use accounting software to automate accrual entries. Tools like QuickBooks or Xero are great options to maintain accurate records.
- Work Closely With Your Accountant
Regularly review and reconcile accruals with your financial team to avoid errors.
- Use Predictive Tools
Rely on data analytics to anticipate accrual needs and streamline expense tracking.
Common Mistakes to Avoid
Even seasoned professionals can slip up when dealing with accruals. Here are mistakes to watch out for.
- Failing to Record Accruals
Skipping accruals leads to incomplete financials, especially at year-end.
- Overstating or Understating Amounts
Miscalculations can throw off reports and affect decision-making.
- Relying Solely on Memory
Forgetting to log activities often results in missed accrual entries. Always use a reliable system.
Why Accruals Should Be a Priority for Your Business
Accruals may seem like a technical accounting topic, but they’re essential for any business operating at scale or seeking external partnerships. By adopting accrual accounting, businesses can better plan for the future, align with regulatory standards, and gain insights that lead to smarter decisions.