Accounting for accruals
In this section, we will explain how accounting for accruals is done in the books of accounts. In the previous section, we discussed why it is important to estimate the cost/expenses which have been incurred, and such expenses needed to be recorded and reported in the financial statements for the period under the accrual basis of accounting.
Accounting for Accruals (Accrued Expenses)
Accrued expenses are recorded by recording the estimated expenses whereas a counter accounting entry is recorded in the Accrual accounts/ ledger. Upon the receipt of an actual invoice from the supplier, the accrual account is reversed backed with the already booked amount instead of the expense amount, and the vendor ledger account is credited.
Let’s learn this concept through the following examples;
Businesses usually pay their employees’ salaries on the 1st of each coming month. For example on 1st June, 20X2, the XYZ Company paid an amount of $5,000 to its employees for the month of May, 20X2 As per the general understanding the accounting entry when cash is paid as a salary to employees shall be:
Dr. Salary Expense $5,000
Cr. Cash $5,000
However, if we record this accounting entry on the day when salary was paid i.e. 1st June, 20X2 the accounting entry will be recorded on 1st of June, 20X2 and eventually reported in the Profit and Loss for the month of June for the salary which pertains to the month of May, 20X2 and shall have been reported in the month of May, 20X2.
To avoid this anomaly, the general accounting practice is to record an accrued liability against salary expense on the last date of May, 20X2 by recording the following accounting entry;
Dr. Salary Expense $5,000
Cr. Accrued Liability $5,000
Now on the day when salary was paid to the employees of XYZ Company, the following accounting entry will be recorded;
Dr. Accrued Liability $5,000
Cr. Cash $5,000
We can see that assuming the accrual basis of accounting and dividing the recording of accounting entries into two stages will ensure that expenses are reported in the exact same month in which those were incurred.
Let’s take another example of an Electricity Company which bills its industrial customers on a quarterly basis. The last bill for the period of Mar-May, 20X2 was received on 01st June, 20X2 for an amount of $1,545. Similarly, the next bill for the period from Jun-Aug, 20X2 is expected to be received 01st September, 20X2. The company prepares its monthly Financial Statements and has adopted an accrual basis of accounting. What shall be the Accounting entries for electricity expenses for the month of June 20X2?
According to the Accrual concept, the cost of the electricity used during the month of June 20X2 shall be recorded in books of accounts and reported in the Financial Statements as an expense.
Since the exact billing for the expense will be received in two months, there could be two methods to estimate the amount of expense on account of electricity consumption.
1. Estimated consumption can be determined by multiplying the power units consumed during the month with the determined electric rates.
2. We can assume that the electric expense for the period from March-May, 20X2 will remain the same for the coming period from June-August, 2022. (We will use this method in our example for illustration).
Accounting entries required to record the accrued electricity expense will be as follows;
Estimated electricity expense for the month of June, 20X2= $1,545/3 = $515
The estimated electricity cost for the month of June, 20X2, will be recorded as follows:
Dr. Electricity Expense (Profit and Loss account) $515
Cr. Accrued Liabilities (Balance Sheet) $515
The amount against expense was recorded into a ledger named “Accrued Liability” instead of supplier accounts. However, after the receipt of actual billing amounts booked into accrued liabilities will be reversed and recorded into the personal ledger of the power supply company and purchase ledger control accounts.
Accounting for prepaid expense
There could be instances where businesses need to pay for the expenses in advance. Let us assume that XYZ Company has rented its office premises for the monthly rent of $250. The quarterly advance Rent is payable on the 1st of May, August, November, and February. The XYZ Company assumes the accrual basis of accounting and prepares its annual financial statements for the period from July to June of the coming year.
During the year ended June 20X2, the XYZ Company paid $750 ($250 X 3) on the 1st of May, 20X2. What accounting entries will be posted at the time of payment and subsequently at the yearend i.e. 30th June, 20X2?
Solution:
At the time of Payment, the following entries will be recorded,
Dr. Prepaid Office Rent $750
Cr. Office Landlord (Purchase control Account) $750
Since the whole rent is being paid in advance, therefore no amount is being charged as an expense, instead, the whole three months’ rent is being booked as prepaid (current asset).
On 30th June, after two months’ time since the advance rent was paid on 01st May, 20X2 the company has enjoyed the tenant ship for two months hence, $500 (2 X $25) shall be charged as rent expense.
The following accounting entries will be posted on 30th June, 20X2, in the books of accounts:
Dr. Rent Expense $500
Cr. Prepaid Rent $500
After posting the above accounting entry, the remaining balance for the ledger “Prepaid Office Rent” will be $250 which reflects the rent for the month of July, 20X2.
