Business and Personal Finance: Accounting for Accruals

The End of Period Cleanup – Accounting for Accruals

When you make an adjusting entry to account for something that hasn’t happened yet, but will, that entry is called an accrual. Accruals, as you might guess, are critical parts of accrual basis accounting, the system that strives to record transactions in the period they most relate to regardless of when they are finalized.

It sounds odd, accounting for things that haven’t happened yet but belong in a past period. That goes back to the matching principle, which requires that you record revenue when it’s earned and expenses when they’re incurred. It does not matter that no money has changed hands yet; only the circumstances of the transaction matter here. For example, even though your savings account only pays interest quarterly, you actually earn that interest every month.

So, accrual-type adjusting entries include both expenses that have been incurred but not yet paid and revenues that have been earned without any cash being received.

Here are some very common examples of expenses and revenues that often need to be accrued:

  • Payroll and payroll taxes
  • Property taxes
  • Interest expense
  • Interest income
  • Bad debts (a.k.a. uncollectible accounts)

Accruals for items such as payroll and payroll taxes are necessary because pay periods don’t usually conveniently end on the last day of the accounting period. If the period ends on Tuesday, but you don’t write pay- checks until Friday, you have to accrue for the two payroll days that happened in this period. The same principle applies for accruing income, such as interest. If your books close on the last day of the month, but your bank pays out interest on the tenth day of every month, you have to accrue interest income for the last twenty (or so) days of this period. Other accruals, such as the one for bad debts, are based on estimates. Today, you don’t know how many customers won’t pay their bills, but you’re pretty sure some of them won’t. However you choose to estimate your bad debt expense, this is the time to record that number.

ALERT!

When the transactions you accrued finally take place, it’s common to accidentally double-count them. To make your life easier, make reversing entries for all your accruals in the very beginning of the new period. The backward entry is the exact opposite of the accrual, so your accounts will show the right net balance when you record the real transaction.

Accounting for Accrued Expenses

The journal entry to record an accrued expense always acts the same, no matter what expense you are working with. Each time, you debit an expense account and credit some kind of liability account. Here you don’t use your standard accounts payable account (which is used for vendor invoices, and must match the vendor ledger), because that could get complicated going forward. Instead, you can create specific accounts for the expense accruals you will have most of the time (such as payroll payable) and use a catchall account for the rest (such as expenses payable).

For example, suppose you have a standard payroll of $1,000 per week paid out every Friday. The current period ended on Wednesday, meaning you need to accrue three days of payroll to account for everything in the right period. Three days of payroll comes to $600 ($1,000 divided by five days, then multiplied by three days).

March 31, 2006

Payroll Expense:  $600.00

Payroll Payable:  $600.00

To record three days of payroll expense.

ESSENTIAL

One way to make sure you catch all the expenses you can accrue is to run through your checkbook for the first few weeks of the next period. Any payments you made for bills that affected the last period count as accruable expenses. This includes things such as your phone bill, utilities—pretty much anything that you use now but pay for later.

Accounting for Accrued Revenue

The most common revenue that needs accruing, at least when it comes to small businesses, is interest on bank accounts. The entry works the same way for any kind of revenue your company has earned for which payment has not yet been received, and no sale has already been recorded (as it would be with your normal accounts receivable activity).

Suppose your company has an interest-bearing bank account for which interest is posted on the fifteenth day of each month. Your April 15 bank statement shows $30 interest paid into the account. Fifteen days’ worth of that interest belongs in April, but the rest really applies to the month before. In this example, you accrue $15 (half of the $30) in March to an interest receivable account (because as of March 31, you had not received the cash in your account).

March 31, 2006

Interest Receivable: $15.00

Interest Income: $15.00

To record interest earned.