Accruals, and accrual accounting.
Used extensively in the business world, but not intuitively clear to everyone.
This short tutorial provides clear and simple examples of the accruals concept and accrual
journal entries, so you can contribute to the discussion in your company next time the
topic comes up!
In many companies, the topic of accruals resurfaces at the end of every period, usually as a variation
on this question asked by the CFO or corporate controller: "Quarter-end is near....
Do you have any accruals that need to be included?"
Most finance people would know what the CFO means here, and the CFO probably assumes the
rest of the business does as well, but that is often not the case.
The question from the CFO could actually mean two things: are there any expense accruals
to be made, or are there any revenue accruals to be made?
You would make an expense accrual when expenses have been incurred for which we have not yet
received an invoice from a supplier.
You would make a revenue accrual when goods or services have been delivered, in other
words the revenue has been earned, but we have not yet actually billed the customer.
Using accruals allows a business to more closely adhere to the matching principle.
Let's start with the most common type of accruals: expense accruals.
Accrued expenses are the opposite of prepaid expenses.
In prepaid expenses, you record the right to receive future services that have already
been paid for but not consumed.
In accrued expenses, you record the obligation to pay for services in the future that you
have already consumed.
Here are some examples of expense accruals, and the related accrual journal entries.
Travel expenses that were paid by an employee out of their personal account, and have not
been claimed back from the company yet by the end of the accounting period.
If the employee communicates in writing the nature and amount of the expenses to the finance
department, then an accrual can be made to correctly state the costs for the period by
debiting travel expenses in the profit and loss statement or income statement, and crediting
accrued expenses on the liabilities side of the balance sheet.
When the employee then claims the travel expenses in the next period, no costs will be incurred
in that period, as the amounts were already accrued for.
Outside services (such as legal services, advertising, or cleaning) that have been received
during the current period, but not yet billed to the company by the end of the period.
An accrual can be made to correctly state the costs for the period by debiting outside
services expenses in the profit and loss statement or income statement, and crediting accrued
expenses on the liabilities side of the balance sheet.
When the invoice does come in during the next period, the accrual amount can be reclassed
to accounts payable.
Bonuses related to current year (or quarter), to be paid out next year (or quarter).
Setting bonus targets, tracking progress, and processing payments is usually a cross-functional
responsibility between HR, finance and functional managers.
An accrual can be made to correctly state the costs for the period by debiting employee
bonus expenses in the profit and loss statement or income statement, and crediting accrued
expenses on the liabilities side of the balance sheet.
When the payments do take place during the next period, this will be a balance sheet
to balance sheet entry, where the accrual is debited and cash is credited.
If you have any accrual examples for your company, then please share them as a comment
below this video.
We will now discuss the second example of outside services in more detail, with numbers
and accrual journal entries.
This month, a maintenance company performed $900 worth of outside services for us.
In the same month, you received $1200 worth of invoices, of which $400 related to last
month's services, and $800 related to current month services.
Your budget for the month was $1000.
The payment sent to the supplier is $600 in the current month.
Which of these numbers should be recorded as the current month expenses?
Expenses should be recorded during the period in which they are incurred,
so $900 is the correct answer.
Let me talk you through why the other options are incorrect, and subsequently talk you through
the related journal entries.
The $400 related to last month's services was accrued last month and can now be released.
The $800 of invoices received related to current month services will be booked into P&L, but
we will have to accrue an additional $100 for invoices to be received.
This $100 is the difference between the $900 of work performed
and the $800 of invoices received for it.
Having a copy of the full set of signed timesheets of the external vendor for the work he performed
for us would be a good basis to make the accrual calculation.
Having a budget of $1000 is a spending restriction, not a dimension of your actual income statement.
If your budget was $1000 and only $900 of outside services was performed, then you underspent
$100 versus the budget.
A payment to the supplier, of in this case $600, is a journal entry that only affects
balance sheet accounts, not expense accounts.
This is the way that example looks in journal entries.
Last month, $400 was recorded as a debit in outside service expenses in the income statement,
and as a credit in accrued expenses liability on the balance sheet.
This month, when the invoices come in, the $400 is reclassed within the liability side
of the balance sheet, by debiting accrued expenses, and crediting accounts payable.
You could also reverse the original journal entry to release the accrual, and then book
expenses versus accounts payable, which has exactly the same effect
but more journal entry line items.
The $800 of invoices related to the current period are recorded by debiting outside service
expenses in the income statement, and crediting accounts payable on the balance sheet.
For the $100 worth of work performed for which no invoice has yet been received, you record
a debit in outside service expenses, and a credit in accrued expenses.
Last step: for the actual payment to the supplier, you debit accounts payable and credit cash.
At the end of the current month, you have $900 of outside service expenses in the P&L,
you have $100 in accrued expenses on the balance sheet and $600 ($1200 minus $600)
in accounts payable related to this vendor on the balance sheet.
Hopefully, the finance department of your company is well organized, and has a list
of "usual suspects" for accruals, so no material amounts are missed.
But what if most of the expense accounting goes through manual accrual journal entries
rather than systems?
This could pose a control risk, as accuracy and completeness are at risk.
For each of the earlier three examples, you could put a system in place with appropriate
routines and controls, if the number of accrual entries and related amounts are significant.
For travel expenses, you can implement a travel and living system with an automated feed to
the general ledger, and get all employees into the habit of feeding this system in real time.
For outside services, it would be good to use a purchase order system, where you can
record the receipt of a service and receipt of the invoice for that service separately,
match the related documents, and use the list of open purchase orders for your accruals.
For bonus target setting, progress tracking, and payment processing, a bonus tracking system
can be put in place.
The second type of accruals is revenue accruals.
Goods or services have been delivered by our company
for which we have not yet billed the customer.
Two examples.
If you are in the service business, you may have performed work to a client under an existing
contract for which you have not billed yet by the end of the period.
You could record this, assuming revenue recognition criteria are met, by debiting the
unbilled revenue asset account on the balance sheet, and crediting revenue in the income statement
or profit and loss statement.
If you ship goods at the very end of the period, after the subledger has fed its data to the
general ledger but before the period is over, you could record these shipments by debiting
the unbilled revenue asset account on the balance sheet, and crediting revenue in the
income statement or profit and loss statement (once again this only applies when revenue
recognition criteria are met).
I hope I have been able to clarify and illustrate the concept of accruals for you.
Remember to put your examples in the comments box below this video.
Thank you for watching!
If you enjoyed this explanation of accruals, then please give it a thumbs up!
On this end screen, there are a few suggestions of videos you can watch next.
Please subscribe to the Finance Storyteller YouTube channel!
Thank you.