Accruals: one of the basic principles of accounting
This post is part of our accounting education series. Finance and accounting, just like taxes, are all around us. To add, it surrounds us like the air we breathe. Finance, accounting and taxes touch our lives. Like death, we cannot escape them. Ignoring these topics in your life is like ignoring that a cup of tea is hot. At one point, it will burn and burn it will. This is especially true for entrepreneurs. No matter what business you engage in, a sound knowledge of at least the basic principles of finance, accounting and taxes is simply a must.
Introduction to accruals
Accruals are an integral part of Finance and Accounting. Without understanding accruals, one cannot properly understand or interpret a Financial Statement.
What is an accrual?
An accrual is an expense or income for which a cash still needs to be paid or received in the determinable future. As simple as that. There is nothing more and nothing less to it.
Now you must be thinking – if there is no cash transaction made for this income and expense yet, then how is it reflected? Is it even recorded? Exactly! — Normally it is not unless a period ends and you allocate a portion of the unpaid income or expense to properly reflect numbers on your books.
Why do we go for accrual-based accounting (again)?
The basic goal of an accrual is to put the expense or income to the accounting period it belongs to. It does not matter if cash has been received yet or not. This is especially important for presenting accurate reports on which business decisions are based on. An accounting based on the concept of accruals is actually very close to the economic performance of an undertaking.
Accruals follow the basic principles of accrual-based accounting. Accrual-based accounting has two major implications in accounting: accruals and deferrals. Today we speak of accruals only. Deferrals will be dealt with in another post. Most accounting standards around the world allow accrual-based accounting only, of course, on the basis of materiality. Meaning, there is no need for accruals if we talk here about an insignificant amount. Based on experience, however, accruals tend to add up – in fact, make up a big, accountants say material, position within the Balance Sheet and the Income Statement.
Is net income equal to net cash received or net loss equal to net cash lost?
There are many more reasons why the answer is no. Hence the answer is no. To focus on our area, one reason we already know: accrual-based accounting. An accrual is a so-called non-cash item. It is one of the reasons why net income or loss is not equal to the net cash received or paid.
Where do I find the actual cash performance of a company?
Net income or loss is an information directly found on the Income Statement. They are called the bottom line. The Income Statement is part of a company’s, an entrepreneurs or even your Financial Statements. Have a look at the Cash Flow Statement, also one of the Financial Statements. There you can see the net cash income or loss. Accruals do not find themselves within the Cash Flow Statement and if they do, they represent an adjustment to convert Net Results to Net Cash Flow.
Examples of typical accruals:
- Regular utility or rental bills for December of a year that are paid some month after. Here, the cash is paid after the expense is incurred. In accounting, we would record an expense in December. The cash Payment is recorded a month after.
- Interest income on a loan given to someone. The interest accrues on a daily, monthly or yearly basis but payment is most of received on some other date.
- Interest expense on liabilities. In addition, most interest income accrues as well. Payment for the interest is usually paid much later.
- Employee bonus. This is usually paid sometime after the close of a financial year or period. The bonus, however, belongs to the year or period the bonus was created by the employee
- Insurance bills. Let’s say you buy an insurance for your building now and it takes effect now. If the insurance company bills you however much later, than the insurance expense should be recorded as time passes buy ahead of the payment to be made.
Super advanced yet still very basic: how to book accruals:
When an expense is incurred:
Debit to an expense account (reduces net income)
Credit to an accrual (liability) account (increases liabilities)
Note: reduces net income; to record accruals
When an accrued expense is paid:
Debit to the accrual account (reduces liabilities)
Credit to cash / bank (reduces liquidity)
Note: has no effect on net income; to pay accruals
When revenue is accrued:
Debit to accrued receivables (increases receivables)
Credit to a revenue account (increases income)
Note: increases net income; to record accruals
When an accrued revenue is received
Debit to cash / bank (increases liquidity)
Credit to accrued receivables (decreases receivables)
Note: has no effect on the Income Statement; to pay accruals
Use Case of an accrual with necessary Journal Entries
Your company usually pays rent for the financial year 2019 on February 15, 2020. Books are closed on a monthly basis to ensure updated management reporting. The yearly payment is $24.000. This is according to a lease contract archived with your accounting department.
What are the journal entries necessary for the year 2019?
What is the entry necessary once the payment for the rent has been made? We assuming that payment has been made on February 15, 2020?
Answer to Q1:
If the accrual is deemed to be material for the monthly management reporting, specifically if this reporting is made available to the public, a monthly journal entry is necessary. Every month, the following journal entries are to be made:
Debit “rent expense” for $2.000 ($24.000 / 12 months)
Credit “Accrued rent liability” for $2.000 ($24.000 / 12 months)
Note: to record monthly rent expense
Should the monthly accrual not be deemed to be relevant for the monthly closing, but important for the yearly Financial Statements, only one accrual entry is necessary as of the financial year end:
Debit “Rent expense” for $24.000
Credit “Accrued rent liability” for $24.000
Note: to record yearly rent expense
Answer to Q2:
Regardless if you recorded you accrual on a monthly or yearly basis, as of December 31, 2019, the following balances are shown in your books:
Rent expense: $24.000 (Expense, Income Statement)
Accrued rent liability: $24.000 (Liability, Balance Sheet)
The expense is associated with the year 2019. The liability stays in the Balance Sheet until after paid or corrected. Once the payment is done, we record the following entry:
Debit “Accrued rent liability” for $24.000
Credit “Cash or Bank” for $24.000
Note: to pay accrued rent liabilities
Finally, your liabilities are paid and the account “Accrued rent liability” shows null. Hence, the account details will show: a Credit of $24.000 and a Debit of $24.000.
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