As the business operations of an entity expand, the scope of departments also increases. Similarly, business entities have to adopt more practical accounting and financial reporting approaches for legal and tax purposes. A business entity can no more rely on pre-made accounting templates to log the transactions. There needs to be a solid accounting approach for financial reporting.
The International Financial Reporting protocols and GAAP(Generally Accepted Accounting Principles) dictate how a company should account for the business transactions and prepare the financial statements. The basic accounting principles help the accounting bodies and business entities to develop their accounting systems accordingly.
For instance, the full disclosure principle dictates the preparation of financial statements, and the revenue recognition principle requires recording income when its earned regardless of the collection time. Similarly, the matching principle requires a business entity to match all expenses incurred in a financial period with the respective revenues.
The matching principle of accounting has given rise to an accounting approach that is most extensively used in business entities. It is called accrual accounting. In this article, we will discuss different accruals in the accounting of any business entity.
What Is Accrual Accounting?
Let’s start with defining accrual accounting.
The Accrual accounting system recognizes the revenues and expenses of a business entity as they occur regardless of when the cash is paid or received. It can also be explained as an accounting system that recognizes the economic events of a business entity just as they happen regardless of when the cash transaction takes place.
As mentioned earlier, the accrual accounting system is based on the matching principle of accounting. The matching principle states that the expenses should be recognized in the same period when the revenue was generated by incurring those expenses.
The counter system of accrual accounting is called cash accounting.
Before the Companies Act 1985, most of the companies and business entities around the globe used the cash accounting system. Until the 1970s, the accrual method of accounting was more common in the private sector industries and business entities.
The 1974 reforms made it a more common accounting system in the local council, but the implications on state and national levels were still not in practice. However, the NHS reforms of the 1990s made the accrual accounting system a norm in all the state and public sector finance.
Accrual Accounting Vs. Cash Accounting
As the name implies, the cash accounting system focuses on recording and recognizing financial transactions and economic events as the cash is received or paid. It was an older approach of accounting when traders used to do the transaction on a cash basis. The balance sheet in a cash-based accounting system does not have any payable expenses or receivable revenues. Financial statements do not record a transaction until and unless the cash has been paid or received.
However, the accrual accounting system recognizes the expenses and revenues irrespective of cash collection or payment. Instead, the liabilities and asset accounts are debited and credited if the cash part of the transaction is delayed. The balance sheet in the accrual accounting system has different accruals on the asset and liabilities side.
Types Of Accruals In Accounting
When the business entity uses an accrual-based accounting system, the transactions are recorded in financial statements and accounting books when either of the aspects is completed. For instance, if a company makes credit sales, the transaction will be recorded by debiting the debtor account and crediting the sales account.
There are so many business transactions that give rise to different accruals in the accrual-based accounting system. Let’s discuss different types of accruals in the accounting of any business entity.
Accrued revenues are the earned revenues that have not yet been received. In short, when the income is already earned by a company but not received, it is recorded in the accounting books as accrued revenues. The accrued revenues are usually recorded in the accounting books when a business entity works on long-term projects, loans, and long-term construction projects. The accrued revenues are recorded on the assets side of the company’s balance sheet.
For instance, a construction company is working on a multi-story building. The building will be used as a shopping mall in the future. The project comprises different milestones based on different timelines. The project will extend to two and a half years. The company has to prepare the financial statements at the end of every financial year. By the end of the first year, the project had not been completed yet.
By the end of the first year, the company has already earned a portion of the total project value. But the income has not been received by the company yet. Therefore, under an accrual accounting system, the company will record the revenues as accrued revenues.
The deferred revenues, on the other hand, are also the earnings of the business entities. However, these revenues are the ones that the company receives before providing the services to the clients. In short, when a business receives cash before delivering the services or goods, the account created is called deferred revenue.
Deferred revenues are usually common in the services business, where clients pay in advance. The insurance companies also have deferred revenue accounts common in their financial statements.
For instance, a client has paid the insurance premium in advance to the insurance provider. The annual premium of the company is 1,500 USD. The monthly premium will amount to 125 USD. The company will record the 1,500 USD as deferred revenue in the liabilities of the balance sheet. The monthly insurance premiums will be debited every month to reduce the liability and credit the revenues earned. By the end of 12 months, the deferred revenues would have been debited, and the whole amount will be credited as sales.
When a business entity pays the expenses before receiving the services or goods, the expenses are recorded as the asset of the business entity. Recording prepaid expenses as assets implies that the business entity will receive the services or goods in the future.
For instance, a marketing agency buys the annual subscription of marketing automation software. The firm will pay for the annual subscription in advance. The annual cost of the software is 1,200 USD, and the monthly cost will be 100 USD. The business entity has paid the expenses at the beginning of the year. However, it has not used the service yet.
As the year passes, 100 USD will be credited from the prepaid expenses per month to recognize the complete charges as the company’s expense by the end of the year.
Accrued expenses are the accrued liabilities of the company and represent the services that a business entity has received before paying for the expenses. In other words, the services have been delivered to a business entity. However, the bill has not been sent to the client yet. The accrued expenses are recorded in the balance sheet of the company as the current liabilities.
There are several categories when we discuss the accrued expenses. The most common accrued expenses of a business are as follow:
- Salary and wages accrual – The company has taken employees’ services but hasn’t paid them yet. The outstanding salary of the employees is an accrued expense for a business entity.
- Interest expense accrual –interest expense on the long-term debt is owed but not yet paid.
- Suppliers accruals – Raw material for manufacturing or finished goods for reselling have been procured from the supplier. However, the expenses for goods and services haven’t been paid yet.
For instance, the company Tecno Inc. has 200 employees working in the plant. The salaries of employees are paid at the start of every month. The salary paid at the beginning of every month is the pay for last month. Therefore, employees’ salaries are accrued expenses of a business entity at the end of every month.
Importance Of Accruals
As the complexity of businesses has increased, the need for more comprehensive approaches to analyze the company’s financial position has also become a necessity. The small business entities might go well with the cash accounting until they decide to expand the business. However, with the increasing size of business, the relevance of cash accounting decreases.
On the other hand, accrual accounting is the more accurate approach to accounting. It highlights the income, expenses, assets, and liabilities of a business entity. Some key features of accrual accounting that make it impeccable are a better assessment of performance, accuracy of financial metrics, and a more realistic future planning.
In A Nutshell,
The more sustainable and accurate accounting system is the accrual-based accounting system for business entities, either small enterprises or large corporations. It covers all the business aspects and accurately reports the income, expenses, assets, and liabilities of a financial period. We have discussed different types of accruals and why a business should go for an accrual-based accounting system.
For more deep insight, the business entities should look up to Financial Accounting Standards Board(FASB)’s outlined Generally Accepted Accounting Principles. These principles dictate when a company should accrue the expenses and revenues and when to not. You can read more about the accruals on FASB’s website. However, businesses residing outside of the USA should follow IFRS Standards.