Accruals, a core component of US GAAP, are journal entries used to recognize revenue or expenses in the period they were earned.
What is An Accrual?
An accrual is a type of journal entry accountants make when a transaction occurs but no cash changes hands. But why would you record an entry when no cash changes hands? Accounting uses accruals to recognize revenue or expenses in the period they were earned.
Accrual Accounting versus Cash Accounting
Cash accounting is very simple. You book revenue and expenses when cash changes hands. Small organizations such as sole proprietorships and partnerships typically use this method.
Accrual accounting books revenue in the period it was earned, not necessarily the period when payment is received. Similarly, you record expenses when you recognize the related revenue. Accrual accounting provides much more realistic views of a company’s financial position. As such, this is the preferred method under US GAAP and most companies have to use accrual accounting.
Accounts adjust the general ledger and financial statement using journal entries. A journal entry is a set of debits and credits (always one for one, but sometimes many sets) to change account balances.
Adjusting entries are an important part of accrual accounting. To be compliant, you need to record revenues and expenses in the correct period. We can think about adjusting entries as accruals and deferrals. If an expense is committed but you haven’t received an invoice, you accrue for the expense to account for the invoice. If you receive cash before you provide the related service, you would defer the revenue to be received at a later date.
- A company pays out performance bonuses once a year. Every month, you post an accrual for 1/12th of the bonus to recognize the expense in the period the employee worked.
- A factory purchases and receives 1,000 widgets in January. By the end of the month, they haven’t received an invoice. Accountings books an accrual for the estimated cost and they reverse it in February once the invoice is in hand.
- Tax payments are due quarterly. Accounting accrues the quarterly taxes each month of the quarter and then writes one check at the end.
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