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Understanding Accruals in Accounting

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Last editedNov 20202 min read

Need to track revenue or expenses that haven't been accounted for yet? If so, it may be a good idea to take a deeper look into accrual accounting entries. An important part of the accrual accounting method, accruals can help you gain a better understanding of the financial health of your business. Explore accrual accounting in a little more detail with our helpful guide, starting with our accruals in accounting definition.

Accruals in accounting definition

There are two main accounting methods to choose from: cash basis accounting and accrual basis accounting. Under the cash basis of accounting, income and expenses are recognised when the money changes hands, but not before. By contrast, the accrual basis of accounting recognises income and expenses are soon as invoices are raised and bills are received, respectively.

So, what are accruals?

It’s relatively simple. Accruals are the accounting entries for the expenses/revenue for which payment hasn’t yet changed hands. Put simply, accruals form the bedrock of the accrual basis of accounting. While accruals may impact your business’s net income on the income statement, it’s important to remember that the cash hasn’t been received yet.

Accruals can be used for a broad range of financial transactions, including accounts receivable, accounts payable, payroll, and so on. Put simply, any form of revenue that has been earned but hasn’t yet been recorded in the accounts, as well as any expenses/liabilities that have been incurred but haven’t been recorded, may be incorporated as an accrual accounting entry.

So, how do accruals work? It’s pretty simple. Essentially, the accountant will make adjustments with adjusting journal entries for revenue/expenses that have been earned/incurred but not yet recorded at the end of the accounting period. It’s also worth noting that accruals are the preferred method of the generally accepted accounting principles (GAAP), which may be important if you’re attempting to expand into North America.

What’s the benefit of using accrual accounting entries?

There are several benefits associated with accrual accounting. For a start, it improves the quality of your financial statements and ensures that you have a much more comprehensive understanding of your company’s financial health. Not only will you have an overview of the cash your business is owed, as well as the money you owe to other businesses, but it helps you to view expenses and income that are upcoming in the next accounting period.

Of course, it’s important to remember that as accrual accounting entries are essentially estimates, the amounts accrued could be incorrect. This could lead to issues with your cash flow forecast, as your operational expenses may have been based on these incorrect predictions. As such, it’s important to note any discrepancies as soon as they occur and amend the entries in your accounts.

Example of accruals

For a slightly more in depth understanding of accrual accounting, let’s look at an example. Imagine that your business’s manufacturing equipment requires some ongoing maintenance work, beginning in the last month of the accounting period. However, the bill won’t be paid until it’s received in the first month of the subsequent accounting period, when the work has been finished.

To ensure that your financial statements are complete, you’ll need to report the expense on the income statement for the current year and report the related liability on the balance sheet as of the last day of the accounting period. Then, to record the accrual, you’ll just need to make an adjusting entry that debits the maintenance expense and credits your accrued expenses payable.

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