Accrual means that the revenues and expenses of an Entity should be recorded in the period they relate to, not when they were received or paid.
How Accrue Works?
Accrue in general terms means to accumulate over a period of time. It is mostly used when referring to the income, expenditures, and interest of a business entity. For example, Interest on a savings account, accrues over a period of time, such that the total amount of interest in that account grows. The term accrue is usually referred to the accrual basis of accounting, which has become the standard accounting practice for most companies that comply with International Financial Reporting Standards (IFRS).
In financial terms, when an entity accrues it essentially builds up a balance to be paid or received in a future time period. Both liabilities and assets can be accrued over a period. The term “accrue” in the context of accounting and finance is synonymous with an “accrual” which is the basis of an accounting method known as accrual accounting that is defined and outlined by the International Accounting Standards Board that is responsible for regulating IFRS and related guidance.
An accrual is basically an accounting adjustment that business entities use as a means of tracking and recording revenues that have been earned and expenditures that have been incurred but are yet to be received and paid respectively.
Accrual accounting basically helps businesses in measuring their financial position and performance by recognizing economic transactions and events irrespective of when cash gets involved in transactions, giving a better and more accurate picture of an entity’s financial affairs at a given date.
This is completely opposite to cash accounting where revenues and expenditures are recorded and reported when they are actually received and paid, leaving out future obligations (purchases made on credit) as well as assets (revenue earned by selling on credit).
While new or some very small business entities use the cash basis of accounting, companies usually opt for the accrual basis of accounting. Accrual accounting gives a far clear and accurate picture of an entity’s financial affairs than cash accounting as it not only requires an entity to records current transactions but also the ones that relate to the near future.
For example, Company AFR has sold a product worth $500 on credit in the month of February, then under accrual accounting, it would have to record that $500 in February instead of waiting until it actually receives cash from the customer.
Type of Accruals
There are mainly two types of accruals:
- Accrued Revenue
- Accrued Expense
An accrual for an income earned is made when an entity sells goods or provides services to its customer on credit. Businesses having large amounts of credit transactions usually have high levels of accrued revenue and accounts receivable.
Assume that a business entity named XYZ hires a Consultancy firm BCD to help them on an assignment that is expected to take four months to complete. The fee Company BCD is going to receive for the said assignment is $100,000, which will be paid upon the assignment’s completion. While XYZ owes BCD $20,000 after each monthly milestone but the total consultancy fee accrues over the life of the assignment instead of being paid monthly on an installment basis.
An accrual for an expense is made when an entity buys a product or renders service on credit. The said expense also appears on an entity’s balance sheet usually under the line item “accrued liabilities” in addition to being charged against income appearing on the income statement. Common types of accrued expenses are as follows:
- Supplier accruals
- Interest expense accruals
- Wage or salary accruals