An accrual is a gradual increase in an amount of money, an amount that adds to an accumulation. The accrual of something – in the world of finance – is the adding together of different investments or interests over a specific period.
In accounting, accruals allow a commercial enterprise or organization to record revenues or expenses for which it expects to receive or spend money respectively in a future reporting period. Rather than posting an income for a service when it is paid, the amount is divided equally each month during those months when the service is performed.
As a verb, ‘to accrue’ means to increase in number or amount over a given period, as in: “Interest will accrue on the investment at a rate of 6%.”
John the window cleaner enters income when he does the job – not when he gets paid – he uses the accrual accounting system. If he had used the cash accounting system, he would have entered one payment in January and two in February. Most companies’ accounting departments use the same system John does.
Accrual vs. cash accounting
It is virtually impossible for accountants to generate financial statements without using accruals, unless a pure cash basis of accounting is used. The accruals must be added via adjusting entries so that the financial statements include these amounts.
Accrual accounting contrasts with cash accounting, a bookkeeping system in which payments coming in and going out are only entered when they occur, and not when the orders are placed or the service is being provided.
Imagine a company – John Doe Inc. – needs to insure one of its buildings. The insurance firm bills John Doe $600 in January and July each year. If each insurance bill is for six months’ worth of coverage, under the accrual method in accounting the company would not record a $600 expense in January and another in July. Instead it records a $100 expense each month of the year.
In a cash accounting system, $600 is entered as an expense in January and then $600 is entered in July, while in an accrual system $100 is entered each and every month of the year.
Luigi enters his fleet insurance expenses monthly – he divides the 4,800 per year total by 12. With an accrual accounting system, you can enter the expense during the months when the service you pay for is being provided – in this case, he has insurance coverage for his taxis 12 months of the year. In a cash accounting system, he would only enter the expense when he paid each invoice.
The problem with cash accounting is that profits and losses for each month can fluctuate sharply. If you do all the jobs in one month but do not get paid until the following month, the first month will be full of costs and little income (high loss) while the next month will be full of income with virtually no costs (high profit)
According to BusinessDictionary.com, accruals are:
“Short-term liabilities which continually occur during an accounting period but are not supported by an invoice or a written demand for payment. When preparing financial statements for that accounting period, such liabilities are estimated on the basis of experience (based on previous payments).
Accrual bonds, also known as zero coupon bonds, pay no interest but are issued at a substantial discount to face value. The money the purchaser makes occurs when he or she redeems (sells) it at full value. CATS (certificate of accrual on treasury securities) are zero-coupon US Treasury issues, sold at a considerable discount to their face value.
When a finance-related item accrues, it essentially builds up to be received or paid in at a future date. Assets and liabilities may accrue over time. That is why, when related to finance, the term ‘to accrue’ is synonymous with ‘an accrual’ under GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards).
Accrued interest refers to the interest that has accumulated since the principal investment of a bond or the original amount of a loan.
Video – Accrual accounting
In this Khan Academy video, you are given an example of accrual accounting. The tutor takes you through each month, and shows that income is entered when the service is performed, and not when the money is received, as the case would be in a cash-accounting system.