What Accruals are?
Accruals are the transactions recorded under the accrual concept of accounting. The accrual concept states that costs should be accounted for when incurred, even if cash is not paid at that point in time. The costs shall be recognized (in the Profit and Loss account) when the costs are incurred, regardless of when they are paid.
The accrual concept is to record all business transactions when they are made, as opposed to only when cash has changed hands. It is an alternative to the cash-basis method of accounting. Accruals are usually recorded as an adjustment of financial statements to reflect the effect of transactions and other events that have not been completed at the reporting date.
It is very important at this stage that you understand and differentiate between the Accrual and Cash basis of accounting
Accrual Based Accounting refers to the accounting system in which events are recorded due to their occurrence and not if the associated cash value has been exchanged or not. For example, a business has used electricity in production in the month of June but will not pay till coming September. According to the accrual accounting system, electricity expense shall be recorded as an expense in the financial statements for the period ended June and shall be charged against the income for the same period to calculate the profit for the period ending June.
In order to accurately assess the profit and exact liability, it is important that the amount of electricity consumed during the month of June shall be estimated and recorded in the books of accounts regardless of the fact that the cost of this expense will be paid later
Cash-Based Accounting, on contrary, advocates that the above-mentioned electricity expense shall be only recorded in September when actual cash for the electricity will be paid.
Despite the importance of reflecting true and fair affairs of the company through Accrual based accounting, cash-based accounting is widely used by governments as Governments keep their records not to earn and calculate profits but to ensure adequate cash flows are available to run the governing affairs. Further, a large number of reporting estimations under accrual-based accounting are also not required.
Application of Accruals Concept
The accrual concept requires that a business record expenses as they are incurred, not when they are paid. It means that, when a transaction has occurred, it must be recorded in the books of accounts as an expense even though the money may not have been paid physically yet. The concept of accrual is based on the idea that the costs incurred by a firm for services performed or products sold should be charged to expense in that period in which such costs are incurred, and not in the period when actual cash is paid.
The following paragraphs will explain how the events leading toward the recording accruals are identified.
Almost every business nowadays uses electric power in one way or the other. The power supply companies send bills to the businesses periodically based on the power consumed during the billing period. This billing period is usually not based on a calendar single month, and it is common for power companies to bill quarterly to their industrial consumers. Even in monthly billing, the cut-off date for meter reading and billing date accordingly will be different from the end date of a calendar month, and you may receive the bill for the month of June/ July on the 12th of July with the due date on the 22nd of July. This means it is very likely the electricity expense may not have been recorded until 30th June in the books of accounts.
In such billing scenarios, the actual cost for the electricity consumed during the month of June will become known and paid in the coming month. Whereas, for the fair determination of electric expense and associated payable to the power company, it is imperative to estimate the cost of electricity consumed during the month of June alone.
Now assume another scenario. It is very common in large cities that businesses to pay quarterly or semiannually office rent in advance. For example, if the rent for the months of June, July, and August is paid in advance during May. According to the accrual concept, only rent for the month of June shall be recorded as rent expense for June and not the whole payment made in May.
The next two sections will explain how both of the above transactions shall be recorded into the books of accounts.
