While everyone knows what cash is, they might have a harder time with an accrual. What exactly is it? An accrual is a portion of an expense or revenue that applies to future business. These accruals are referred to as receivables and payables, and they are either expenses that have not been paid, or revenue that has not yet been received.
Why do companies use accruals? The main reason is to keep expenses and revenues in the correct reporting period. For instance the electric bill could cover the month of January. If it's not paid until February, a cash based system would show that expense in February. What happens if February's bill is also paid that month? The electric expense for February would be overstated, throwing off the income statement for that month.
What Exactly is an Accrual?
That is why accruals are used. To not only keep expenses in the correct month, but to make sure they are evenly spread throughout the accounting cycle. Another good example of an accrued expense is payroll. If the final payroll in December had a cut off date of the 28th, those final 3 days would be expensed in January. In order to make sure that expense is recorded in the correct month, an accrual would be journalized in December and then reversed in January.
As detailed above, there are two ways of keeping track of accrual expenses: by either entering the bill in the correct month in accounts payable, and by posting an accrual entry in the general ledger.
Accounts Payable, Receivable and the General Ledger
What about accrued revenues? The same rules apply as for accrued expenses. If a customer has credit with a business, he/she can buy product or services and then pay later. This revenue becomes a receivable for the business, while the actual money is expected in a future accounting period. Once cash is received, the receivable account would be credited instead of the revenue account.
Accrued revenue can also be entered through the general ledger, same as accrued expenses. If cash is received for services that fall within two months, half of that revenue can be accrued and then posted in the correct month. Again, it would be posted in the first month and then reversed in the following month.
For those businesses that find accrual too complicated but don't want to use just the cash method, it is possible to use a combination method of the two. While the IRS does have restrictions on using combination accounting, this method does allow for a bit more freedom for those that want the best of both.
What About Combination Accounting?
While there is no cut and dried explanation of combination accounting, it can be any variation of the cash and accrual methods. Let's say a business wants to use cash for its bills and revenue, but it wants to journalize accruals at the end of the year. Or they do not wish to do any journal entries but want to use accounts receivable and payable, or they have prepaid expense and unnearned revenue. Whatever combination method is used though, it must be used consistently for both income and expense.
In summary, cash based accounting is ideal for a sole proprietor who has no inventory and accepts cash on delivery. Accrual is best for a large manufacturing company that creates products from its inventory. Combination could be used by a variety of companies that fall between those two extremes.
Judith Lee - Judith has been a writer for over two decades. She is also a blogger and book/movie reviewer.
