If you’re studying accounting or finance, you’ve probably come across the topic of accruals. However, this can be a confusing concept to delve into. In this article, we’ll delve into accrual accounting in much simpler terms so that anyone can easily understand it, even the ones who don’t have a background in accounting and finance.
What Is Accrual Accounting?
In financial accounting, the term “accrual” indicates the process of recording the revenues that a company has been able to earn but hasn’t received the actual payment for, along with any expenses that the company has yet to pay. Accrual accounting is based on the matching principle, which states that expenses and revenues should be acknowledged within the same time period when they were incurred.
As a result, this method of accounting has an overall impact on how the balance sheet and income statement are being handled. The accounts in question include future interest expenses, non-cash-based assets, accounts payable, goodwill, and many others.
What Does Accrual Mean in Simple Terms?
Now that you have a better understanding of what accrual accounting means, what does “accrual” mean exactly? Well, if businesses received payments for revenues during the same time they were earned, or perhaps made payments for all the their expenses when they were made, we wouldn’t have any need for accruals at all. However, this isn’t the case most of the time.
In reality, businesses usually have earned revenues that they didn’t receive cash payment for yet, and for that reason, they need to account for those. This same concept can be applied to expenses—if a business purchased something and didn’t pay for it yet, then this expense needs to be accrued.
Different Categories of Accrual Accounting
When we talk about accruals in accounting, this doesn’t just refer to one particular concept. So as mentioned, this could either be revenues a.k.a receivables or expenses a.k.a payables. This is important information to remember, so let’s talk about it more in detail.
When we say a company has an accrued expense, this means that the company bought something on credit and notes down liabilities in the company’s general ledger. The notes also acknowledge that the company still has unfinished obligations to its creditors. In the world of accounting, this means that the company has incurred an expense, but they have yet to pay for it.
Common examples of accrued expenses include the following:
- Salary accruals: Salary accruals are when a company still owes wage to employees who have only worked for a part of the month and haven’t received their full monthly salary.
- Suppliers accruals: This is when a company has to pay for operating expenses for services (or even goods) provided by a supplier.
- Interest expense accruals: This is when a company has interest expenses that they have yet to pay.
The next category is accrued revenues, which refers to assets (including non-cash ones) or income that a company hasn’t received yet. In other words, a company offers its goods or services to another company or individual on credit, which means it has yet to receive cash payment.
One great example for this is electricity consumption. As we all know, our local electricity companies provide us their services before actually receiving payment for our consumption. The electric meter is responsible for keeping track of our consumption, and once we reach the billing period, that’s when we pay the company for its service.
Difference Between Prepaid Expenses and Accrued Expenses
What about prepaid expenses? Well, this concept is the exact opposite of accrued expenses. While accrued expenses allows customers to pay for goods or service at a later date, prepaid expenses refers to when a company or individual pays for its purchases upfront before being able to receive them.
We hope our explanation helped you understand accrual accounting better. The world of finance can be a daunting one, and it has countless methods and concepts that seem too hard to understand. If you have any further questions, don’t hesitate to ask and clarify.