Accrual
In business, “accrual” is an important accounting term. It means recording revenues and expenses as they happen, even if cash has yet to be received or paid. This approach helps businesses get a clear view of their financial health by showing what they owe and what others owe them.
What Is Accrual?
Accrual refers to recording transactions in the accounting period when they happen, even if the cash has yet to change hands. For example, if a business provides a service in December but receives payment in January, the revenue is still recorded in December. This process is part of the accrual accounting method, widely used by businesses following Generally Accepted Accounting Principles (GAAP).
Why Is Accrual Important?
Accruals are important because they help provide a true representation of a company’s financial position. Recording transactions as they occur allows a company to track its income, expenses, assets, and liabilities more accurately. This method ensures that all revenues earned and expenses incurred during a period are included in the financial statements for that period.
Key Terms Related to Accrual
- Accrued Revenues: The company has earned these revenues but has yet to receive them. For example, if a company has completed a project but has not yet received payment, the revenue is recorded as “accrued.”
- Accrued Expenses: These are expenses that a business has incurred but has yet to pay. For instance, if a company receives services in June but will only pay for them in July, the expense is recorded in June.
- Accounts Receivable: The company owes money for goods or services it has received but has yet to pay for. It is an example of an accrued revenue.
- Accounts Payable: A company owes money for services or goods it has received but has yet to pay for. It represents an accrued expense.
How Accrual Accounting Works
The accrual method records expenses and revenues when they happen, even if there is no cash exchange. For example:
- Revenue Accrual: A company provides services in December, but the client will only pay in January. In accrual accounting, the company records the revenue in December when it completes the service, not when it receives the payment.
- Expense Accrual: A business uses electricity in December but receives and pays the bill in January. Under the accrual method, the company records the expense in December when it uses the electricity, not when it pays the bill.
Examples of Accruals in Action
- Employee Bonuses: If employees earned a bonus in December but will receive payment in January, the company records the bonus expense in December.
- Utility Bills: The utility company records the expenses in December when it uses the electricity, even though it pays the bills in January.
- Rent Expense: If a company uses office space in December but pays the rent in January, it records the rent expense in December when the space was used.
- Sales Revenue: If a company delivers products in December but doesn’t receive payment until January, it still records the revenue in December when the sale occurred.
Accrual vs. Cash Accounting
Unlike accrual accounting, cash accounting records expenses and revenues only when the cash is received or paid. Cash accounting may be more straightforward for small businesses or those that operate on a cash basis. However, it doesn’t provide as detailed a picture of the company’s financial position as accrual accounting does.
Conclusion
Accruals are essential for showing a company’s accurate financial picture. By recording transactions when they happen, not just when cash changes hands, businesses can better track what they earn and owe. This helps them make smarter decisions, manage finances more accurately, and present clear financial statements to investors and stakeholders. Accrual accounting gives businesses a clearer view of their financial health and helps them plan for the future.
