What Are Accruals? A Guide to Accrual Accounting
All businesses have financial statements. There are several different types of them, and all of them are important to how a business runs. However, there are certain scenarios that impact financial statements more than others. One of these major impacts comes from accruals. If you’re new to business, you may not know everything you need to know about accrual accounting. Learn more about the accrual method here!
Here’s What We’ll Cover:
What Are Accruals?
Accruals are earned revenues or expenses incurred that impact a business’s net income. They also have a major impact on the income statement. However, the money for these revenues or expenses haven’t yet gone out or come in.
In addition to affecting the income statement, they also have an effect on the balance sheet. They involve non-cash assets and liabilities. The liabilities involved are current liability, as well as future liabilities.
An accrued expense is an expense that’s recognized on the books before it has been billed or paid. It is documented as it is incurred. It is also known as an accrued liability. Examples of accrued expenses are standing orders with suppliers. They can be calculated for before a supplier invoice is sent to the business. In cases like this, expense accounts may be set up ahead of time, such as an office supplies expense account. Cash is then drawn specifically from there based on office supply purchases.
An accrued asset is also known as an accrued revenue. Revenue accruals happen when goods or services have been rendered, but no payment has been received yet. They are considered to be receivable accounts on the balance sheet, and are recorded as such. This is a common practice among the service industry. Companies like consulting services are normally held on retainer, and paid per accounting period. Consulting companies will list their services and costs as revenue accruals. These entries will appear in the books between accounting periods.
What is the Accrual Accounting Method?
The accrual accounting method is one of two distinctly different accounting methods. The other accounting method is the cash basis accounting method. The accrual method of accounting measures a company’s performance by recognizing economic events. This is regardless of when cash transactions occur. The cash accounting method only records transactions when payments occur.
How Does it Work?
The accrual method relies on the matching principle. It matches revenues to expenses at the time when the transaction occurs rather than when payment is sent or received. This allows for current cash flows to be combined with future expected cash flows. For example, if a company can anticipate what money it will be generating based on transactions, it can add to the company’s value. At the same time, knowing how much money is outbound can prevent the company from making purchases that could damage it.
Accrual accounting is the preferred method of accounting for most businesses. The exception would be very small businesses, or individuals practicing business. Because very small businesses and individuals deal in immediate payment, they can use the cash accounting method. Any business that offers internal credit transactions will be better off relying on the accrual method.
Different Types of Accrual Accounts
There are several different kinds of accrual accounts in the accrual accounting method. Some are commonly used, while others are specialized. A list of accrual accounts are listed below:
- Accounts Payable: When a business is expecting to pay for goods or services, it is a ‘payable.’ These accounts represent cash outflow.
- Accounts Receivable: When a business renders a service on credit, they expect to receive payment for it. Accounts receivable represent cash inflow.
- Accrued Interest Earned: This refers to any interest earned on money owed. It is considered a form of cash inflow.
- Accrued Tax Liabilities: Accrued tax liabilities are any taxes incurred that a company has not paid yet.
Depending on the size of the business, there may be entire departments dedicated to payables and receivables. An accounts payable department is dedicated to verifying transactions before making payments. An accounts receivable department is dedicated to collecting payments. The accounts receivable department may be called the collections department.
The accrual accounting method is the preferred accounting method of most businesses. It allows them to keep records of upcoming payments. It matches transactions to cash inflows and outflows. If your company deals in credit transactions, then using the accrual accounting method is right for you. If you need more accounting help, check out our resource hub! There are plenty of articles available for all your business needs.