Accrual breakdown: Comprehension of accruals, functioning of accrual accounting, and case studies
Traditional businesses often deal with a gap between when money is earned or owed and when it actually changes hands. This discrepancy is where accruals come into play. Accruals represent money that's earned or spent but hasn't yet been received or paid, like when you buy something on credit or get paid for work a month after you've done it.
In essence, accruals help businesses paint a better financial picture by recording transactions when they occur rather than when the cash flows. This method, known as accrual accounting, is favored by international financial standards, such as the International Financial Reporting Standards (IFRS), and accounting principles worldwide, like generally accepted accounting principles (GAAP).
The Importance of Accruals
Think about it this way: If you only focused on what's in your checking account right now, without considering your bills or the money others owe you, you'd have an incomplete view of your finances. Accruals help businesses avoid this pitfall by ensuring that unpaid revenues and incurred expenses are taken into account.
Let's explore a few examples:
- An accrued expense might be a tax bill. The tax you owe comes from the previous financial year and isn't due until later.
- An accrued revenue could be a product or service sold on credit.
Without accruals, businesses would only show income and expenses related to the cash flowing in or out of their bank accounts. This approach, however, wouldn't provide an accurate reflection of their economic activity within each reporting period.
Accrual Accounting vs. Cash Accounting
The most common alternative to accrual accounting is the cash basis of accounting. This method is straightforward-you only record money when it enters or leaves your bank account. In contrast, accrual accounting requires that companies record revenue when cash is received and expenses after they are paid. Larger companies are usually required to use accrual accounting, as it offers a more accurate picture of their business's activity and finances.
Keeping Track of Accruals
In accrual accounting, accountants need to enter, adjust, and track revenues and expenses from when they are earned or incurred to when they are finally paid. Using the double-entry accounting technique, they make journal entries, which affect both the balance sheet and income statement.
For instance, when a company sells a product on credit but hasn't received payment yet, an entry would be made to debit the accounts receivable (an asset) and credit the revenue (on the income statement). This action increases the company's revenue and assets in their financial statements. Similarly, when expenses are incurred but not yet paid, an entry is made to debit expenses (on the income statement) and credit accounts payable (a liability).
Understanding Accrual Types
There are four main types of accruals:
- Accrued Expenses: Expenses incurred but not yet paid for, such as utility bills. In this case, the cost needs to be recorded as an accrued expense.
- Prepaid Expenses: Expenses paid upfront before they are fully consumed. Examples include retainer fees for lawyers or consultants.
- Accrued Revenue: Money owed to a company for goods or services provided but not yet received. For example, a company might sell goods on credit, and the outstanding amount should be recorded in an accrued revenue receivable account.
- Deferred Revenue: Money received before delivering a good or service to a customer. This can happen with online retailers that require payment before shipping, or subscriptions that are typically paid in advance.
Practical Examples of Accruals
Accruals are regularly encountered in business transactions:
- Utilities: Much like electricity or water, which are provided before payment, will be recorded as an accrued expense in the company using them. The utility provider, however, would record the revenue earned upon the service's consumption.
- Taxes, interest, wages, and bonuses: These are typically paid in arrears. In accrual accounting, they need to be accounted for in the period they were incurred.
Accruals are essential for ensuring that businesses maintain an accurate record of their finances. By recognizing transactions when they occur, rather than just when cash changes hands, businesses can make informed decisions about their financial health and future growth.
- In the realm of modern business,especially in the context of decentralized finance (DeFi) and cryptocurrency, tokens like digital assets or stablecoins can be considered as accrued revenues when they are earned through mining, staking, or trading activities, but yet to be received in the computerized wallet.
- The technological advancements in business have given rise to various methods of accounting, such as accrual accounting and cash accounting. Larger tech businesses, particularly those involved in the Defi space, are mandated to utilize accrual accounting due to the significant advantage it provides in presenting an accurate representation of their activities and financial status.
- As businesses navigate the complex world of finance and technology, keeping track of accruals becomes crucial in maintaining an up-to-date and comprehensive financial picture. This process often involves the use of the double-entry accounting technique, where token-based accrued revenues are recorded as debits to accounts receivable and credits to revenue on the income statement, adding to the company's reported revenue and assets.
