What are Accruals for Expenses?

The accruals principle states that expenses must be recorded in the period in which they were incurred, regardless of when they were paid. 

This becomes especially important around the year end where invoices for certain expenses, such as rent, heating and lighting may not have been received yet. The expenses have been incurred but, as of yet, the company has not had to pay for them.

The reason that accruals are important is that they help to give a true and fair view of the business’ activities in the financial year within the financial statements.

Let’s take a look at an example:

Company X has a year end of 31/12/2019.

The business started renting a property from 01/04/2019 and the rent for this property is invoiced every 12 months – payable upon being invoiced. The annual rental charge is £12,000

This is how the accrual comes about:

The business has been using the rental property for 9 months by the time its year end (31/12/2019) comes about. This means, in theory, that it has incurred 9 months worth of rental expenses that it has not yet been invoiced for (and therefore, remains unpaid).

This means that at the year end, we must accrue for 9 months worth of rental expense with the following double entry:

Dr Rental Expense

Cr (Rent) Accruals 

The amount of the journal is simply calculated by dividing the annual charge by 12 to find the monthly charge then multiplying this amount by 9 to find 9 months worth of rent:

£12,000 / 12 = £1,000

£1,000 * 9 = £9,000

Therefore the final journal entry to be posted is:

Dr Rental Expense £9,000

Cr (Rent) Accrual  £9,000

What Does the Journal Do?

By debiting the rent expense account we increase the amount of expense in that account for the year.

This means that £9,000 of rent will go through the profit and loss account in the year which is the true rental expense for the year.

On the other side we increase the accruals account – which is a creditor balance. In other words we create a liability on the balance sheet. This is another crucial aspect of accruals: they represent the amount owed to a supplier, even if they have not yet asked for the money. This means the liabilities on the balance sheet are more accurately stated and avoids amounts being missed from creditors.

What happens when the invoice is received?

When the invoice for the goods is actually received and the amount becomes payable to the supplier, we must “release” the accrual. By doing this we remove the accrual balance from our balance sheet and recognize the amount as an actual trade creditor.

This is a simple journal to put through as the expense was already recognized in the previous period.

When the invoice comes in, here are the journal entries required to release the accrual:

Dr (Rent) Accrual £9,000

Cr Trade Creditors £9,000

The debit of £9,000 cancels out the original accrual put into place and the credit is the recognition of the trade creditor which will now sit on the trade creditors ledger.

Summary

Accruals are a useful (and necessary) way of recognizing expenses in the correct period and also accounting for the liability due for the expense which has not been paid for yet.

They ensure the expense figure is stated accurately in the profit and loss account and that the liabilities are stated accurately on the balance sheet.