The accruals concept is one of most important accounting concepts to understand. It forms a crucial role in ensuring the accuracy of the financial statements.
Accruals can often confuse those who are new to accounting but essentially the accruals concept looks to make sure of one thing:
Revenue and expenditure are recognized in the period in which they were earned or consumed.
For this reason, the accruals concept is sometimes referred to as the “matching” concept as it helps to match revenue and expenditure to the periods in which they actually relate to, not just when the cash changed hands.
In order to ensure that they meet the requirements of the relevant reporting framework, finance teams use journal entries known as “accruals” to comply with the accruals basis of accounting.
When are Accruals Used?
Accruals normally form the adjusting journal entries that accountants post at the end of a reporting period:
This is most likely to be when producing the monthly management accounts or the year end financial statements.
They will be posted on the last day of the period in order to ensure that all the relevant expenditure and revenue has been captured in the correct period.
What are Some Common Examples of Accruals?
One of the most common accruals we see, both in textbooks and in the real-world, is the rent accrual.
Many businesses will pay a monthly rent for their office or warehouse. It is a common practice for this rent to be paid in arrears:
This means that the rent for each month is paid in the following month. I.e. January’s rent is paid in February, February’s rent is paid in March and this continues throughout the whole lease term.
This is where we need accruals.
Imagine a company pays rent in arrears and has a year end of December. At the 31st of December, a full month’s worth of rent has been been “consumed” but the business will not pay for this in January.
Under the accruals concept the expense has been “consumed” (the building has been used for a month) and therefore the expense must be recognised within the income statement. To do this we must also recognise the rent liability on the balance sheet.
The journal entry required to account for this would be:
- Debit Rent Expense
- Credit Rent Accrual
It is also common for businesses to recognise accruals for electricity, gas and water that have been used in the year but not yet paid for.
While these are common, there are many more complex accruals that a business may recognise such as bonus accruals, holiday pay accruals and sick pay accruals (as well as countless others depending on how the business operates).
Another very common example of where accruals are required is in relation to goods received by a business, that they have not yet been invoiced for.
This is commonly referred to as a goods received not invoiced accrual, or simply the GRNI accrual.
For example, imagine a business received a delivery of goods in the last week of the financial year but the supplier didn’t sent the invoice until the following week.
At the year end, the balance would not be on the creditors ledger because no invoice could be posted. So instead, a GRNI accrual is made to reflect the fact that the company does owe the supplier for goods, they just cannot recognise a true trade creditor for the balance yet.
To do this, the journal entry would be:
- Debit Inventory
- Credit GRNI Accrual
If you want to know more about the journal entries for accruals, we have a more in-depth post which can be found here.
What About Accruals for Revenue?
Accruals for revenue are often given less attention in beginner accounting textbooks. Perhaps this is because they are not as common in practice.
However, revenue accruals do still occur and are equally as important as they ensure the accruals concept is being applied to revenue.
Accruals for revenue are known as “accrued income”. This is when a service/product has been delivered to a customer but the customer has not yet charged.
Accrued income is very similar to recognising a trade receivable but there is a crucial difference: to recognise a trade receivable the goods/services have to have been billed.
Examples of Accrued Income
Accrued income tends to occur in service-based businesses, especially in professional industries.
If we take the example of accountants or lawyers, these professions may work on a job for months at a time and only bill their clients in stages or at the end of the work.
Each portion time they spend working on that client is classed as revenue because they have performed a service. However, the client hasn’t yet been billed for this service.
Therefore, accrued income must be recognised.
To do this, the following double entry must be made.
- Debit accrued income
- Credit revenue
By doing this, an asset (accrued income) is recognised on the balance sheet to represent the fact that at some point, the customer will pay us for these services. Secondly, the revenue for the services performed get recognised in the p&l which ensures the accruals concept is being complied with.
What Happens When the Customer is Billed?
When the work is fully completed, the customer will be billed – this is normally done by issuing them with an invoice.
At this point, the only thing that should change is the classification on the balance sheet as we have already recognised the revenue.
Instead of the asset being classed as accrued income, is can now become a trade receivable:
- Debit trade receivables
- Credit accrued income
Summary
In summary, accruals are a crucial part of the financial statements and help to ensure that they show a true and fair view of the company’s activity for the relevant period
Accruals are made for expenses and also revenue to make sure that only the amounts incurred/earned in the period are shown in the financial statements.