Accrual
An accrual in accounting refers to the recognition of revenues or expenses in the financial statements before the cash is received or paid, respectively. Accruals are a core concept of accrual-based accounting, which aims to match revenues with the expenses incurred to generate them, ensuring a more accurate representation of a company’s financial performance and position.
There are two main types of accruals:
- Accrued Revenues: These are revenues earned by a company for providing goods or services but have not yet been billed or received as cash. Accrued revenues are recorded as assets (accounts receivable) on the balance sheet and as revenues in the income statement.
For example, a company provides consulting services to a client in December but does not issue the invoice until January. The revenue from the consulting services is accrued in December, even though the cash payment will be received later.
- Accrued Expenses: These are expenses a company has incurred but has not yet paid in cash or recorded in its accounting records. Accrued expenses are recorded as liabilities (accounts payable) on the balance sheet and as expenses in the income statement.
For example, a company receives utility services in December but does not receive the utility bill until January. The expense for the utility services is accrued in December, even though the cash payment will be made later.
Accruals are essential in accounting because they help companies more accurately match their revenues and expenses to the periods in which they are earned or incurred, providing a clearer picture of a company’s financial performance and health.
Example of an Accrual
Let’s consider an example of both accrued revenues and accrued expenses for a company named XYZ Services.
Accrued Revenues:
XYZ Services is a consulting firm that operates on an accrual basis. In December, XYZ provides consulting services worth $10,000 to one of its clients. However, the invoice for this project will not be sent to the client until January. Even though the cash payment has not been received yet, XYZ Services recognizes the $10,000 as accrued revenue in its December financial statements.
In this case, XYZ Services would record the following journal entry in December:
Debit: Accounts Receivable (Asset) – $10,000 Credit: Consulting Revenue – $10,000
This entry reflects the recognition of revenue in the income statement and the increase in accounts receivable on the balance sheet.
Accrued Expenses:
In the same month of December, XYZ Services uses electricity for its office, but the company will not receive the bill for $1,500 until January. Despite not having paid the bill yet, XYZ Services recognizes the $1,500 as an accrued expense in its December financial statements.
In this case, XYZ Services would record the following journal entry in December:
Debit: Utility Expense – $1,500 Credit: Accrued Expenses (Liability) – $1,500
This entry reflects the recognition of the utility expense in the income statement and the increase in accrued expenses (a liability) on the balance sheet.
These examples demonstrate how accruals help to accurately record revenues and expenses in the periods they are earned or incurred, providing a more accurate representation of a company’s financial performance and position.
