What is Accruals Concept in Accounting?
Accruals in Accounting are the expenses or revenues that have been recorded by the firm but not yet realized. In simple terms, they are the financial transactions which have already been estimated in the current accounting cycle even though the payment for which are done in the future. These payments have been recorded based on estimations and credit. They are an integral part of record keeping as they help in presenting a fair and transparent picture of business transactions.
If not done so, they may lead to a scenario where even though the actual financial numbers of a quarterly statement are bad, they might look good because they got compensated by the payment received from the goods delivered from the previous quarter. Thus, presenting a very confusing picture to the investors and misguiding them.
Types of Accruals in Accounting
There are multiple types of accruals in accounting based on the type of transactions they have been recorded for. However, most of the accruals in accounting can be classified into two major categories:
#1 – Expense
Accrued Expenses are recorded when goods, services or raw materials have been received by the firm but the promised payment to the suppliers is still pending. So ideally these expenses have not incurred yet but will be incurred in the near future.
#2 – Revenue
Accrued Income is recorded when finished goods and services have been delivered to the consumers or vendors but the payment for the same has not been received yet. These are similar to the first classification with the only difference that in this case payment is anticipated by the firm in the near term.
Examples of Accruals Concept in Accounting
Let’s see some simple to advanced examples of accruals in accounting to understand it better.
Consider an FMCG firm who sells products to the retail stores. These products are finished goods and can be sold to the consumers and are worth 25,000 $. Now the retailer does not make this payment upfront but promises to pay the amount in the next quarter. Let’s consider the table below which summarizes the sequence of events.
Hence even though the amount was received on 1 Apr for the goods delivered on 1 Feb, in accrual-based accounting such accruals will be recorded as accounts receivable on 1 Feb itself. On the other hand, in cash based accounting such revenues are accounted or recorded only when the actual payment is received.
Let’s consider a practical example. Refer to the following screenshot depicting Amazon.com financials.
Here, one can observe that in the Accounts receivables section, the firm has recorded some numbers. These denote the payments that the firm is expected to receive from its customers as the services or the goods for them have already been delivered. But since this payment has not yet been received, there is a credit risk involved as there is an element of uncertainty and that is why the firm has also recorded Bad debt or doubtful accounts. This is a good accounting practice and helps in removing the ambiguity of the accrual-based revenues.
Advantages of Accruals in Accounting
- Accruals provide a holistic approach of the business to the firm. One must agree that business is not only about cash transactions but about many other features like providing contractual services, providing repeat business and most importantly retaining customers. Such features lead to payments which are not done at a particular point of time but are distributed across varying installments in the future.
- Accruals provide a very clear and transparent picture of the current financials of the business to the investors for a particular accounting period.
- Accrual-based accounting is very helpful especially for a business that holds inventory as the payments for these are always delayed. Recording the payments when they are obligated rather than when they are realized helps the owners in keeping track if the business is making money or in fact losing it.
- By reflecting the sales and accrued expenses at the point when the goods are delivered helps in preparing financial statements that can be compared over different periods of time providing a better way of analysis for investors.
- The very nature of accruals provides the biggest disadvantage. Since the cash has not yet exchanged hands, it can provide a very contrasting picture of the firm financials. An extreme case can be when the firm has accounts receivables in a million dollars because of the goods and services delivered to the retailers but the actual cash with the company is only 1000 $.
- Accruals, both expenses, and receivables are based on the expectations that the payment will be received in the future. An implicit assumption over here is that the debtors will fulfill the obligation. However, that is rarely the case as irrespective of the business in which the firm operates, there will always be some debtors which might not make payments on time or may default completely. Hence the accruals which were recorded as receivables might not be realized completely. Many firms record such payments as bad debt or doubtful payments to counter such an unfavorable scenario.
Limitations of Accruals in Accounting
- Although providing a better comparable picture of financials, accrual-based accounting is complex. Compared to the intuitive method of cash-based accounting, it is both harder to implement and much harder to maintain. This is the primary reason why small firms are allowed to follow any method, but larger firms are obligated to follow accrual-based accounting.
Important Points to Note
- Accruals are in sync with the matching principle of accounting which states that firms should record revenues earned and the expenses incurred both in the accounting period in which they are incurred. Here the importance is more on recording transactions than realization.
- Because of the transparency it provides, large business (greater than 5 million $) are obligated to record accruals by the regulators.
Accruals, both expenses, and revenues have increased the recorded information on the financial statements making it more descriptive, informative and less open to interpretations. They help an investor gauge the current financial health of the firm, future challenges if any and how the firm is trying to tackle these challenges.
This has been a guide to what are Accruals in Accounting. Here we discuss the types of accruals concepts in accounting along the examples, advantages, disadvantages, and limitations. You can learn more about accounting from the following articles –