What is Accruing?

An accrual is like recording an IOU…

When a business buys something, it doesn’t always pay for it immediately. It promises its supplier that it will pay the bill at a later date, giving the supplier an IOU. Similarly, when a business sells its goods or services, its customers may promise to pay at a later time. An accrual is like recording those IOUs on the company’s books. It lets everyone know the commitments have been made already, regardless of when they’re going to come due.

Accruing means accumulating something over time. For example, a bank account accrues interest over time. In the world of finance, accruing refers to a method of accounting where businesses accrue expenses and revenue before making or receiving payments. This method of accounting is called accrual accounting.

Generally Accepted Account Principles (GAAP) is the accounting standard the Securities Exchange Commission (SEC) promotes. Most businesses adopt the GAAP standard, which states that companies can accrue things like:

• Accounts payable
• Accounts receivable
• Goodwill
• Future tax liability
• Future interest expenses

Accruing works by recording revenue, expenses, or other changes to the income statement and balance sheet when the transactions causing those changes occur — rather than recording them when the payment happens.

For example, a coffee shop agrees to purchase coffee beans from a supplier at the cost of $10,000. The supplier agrees to receive a payment within 30 days of delivery. When the shop gets the beans from the supplier, the coffee shop accrues a $10,000 debt. No money has changed hands, but the cost appears on the coffee shop’s balance sheet as an accrued credit in accounts payable. An equal debit for inventory also accrues on the shop’s books.

Later, the coffee shop manager pays the invoice for the beans. Now that money has changed hands, the business can remove the accruals from its ledger. They would reverse, and the payment would create a $10,000 debit to inventory and a credit to cash.

Accounts payable is a current liability account on the balance sheet, referring to the amount that a business has already committed to paying its suppliers in the immediate future. This includes purchases for which the suppliers have submitted invoices and the payment due date is known — Not every entry within this account is an accrual

Expenses are items on the income statement that show what costs a company has incurred in the period being reported. So, an accrued expense is an expense that is reported even though it hasn't been paid for yet. For instance, a company may have an accrued expense for supplies it received and hasn’t paid for.

In general, an accrued expense entry will result in an accrued accounts payable entry as well — if you’re recording an expense you still owe money for, then you also need to log the amount of money owing (the accounts payable). They’re like opposite sides of the same coin.

However, the offset of some expenses may belong to another account. For instance, wages earned but not yet paid (accrued expenses) are often recorded under wages payable on the balance sheet.

Accrual accounting is when all business transactions are accounted for as they're incurred, instead of when they're paid for.

Accrual accounting is the accounting method supported by the Generally Accepted Accounting Principles (GAAP) standard. The Securities Exchange Commission (SEC) encourages the use of GAAP principles (and requires it for publicly traded companies), so most businesses in the United States use accrual accounting.

One benefit of accrual accounting is that it offers a fuller view of a business's financial position. A company could have $1 million in the bank, but $2 million in accrued expenses for which it has not yet paid. Looking only at the cash in its account, and not accrued expenses, gives a poor view of the company’s finances.

A drawback of accrual accounting is that it can be complicated. It is not uncommon for businesses, particularly smaller ones, to make mistakes when using accrual accounting. It can also be easier to hide fraud when using accrual accounting.

Cash accounting is a method of accounting that only records revenue and expenses when cash changes hands. There is no accrual of costs or sales, and transactions are only recorded when payment is received or made.

Many small businesses and self-employed people use cash accounting because of its simplicity. They can just note when the company spent money or received payment.

Though cash accounting is easy to use, it has downsides. Primarily, it can result in a skewed view of a business’s financial situation. For example, suppose a company receives supplies and an invoice to pay for those supplies within 30 days. Over the next three weeks, it turns those supplies into finished goods and sells them to customers who pay on the spot.

The company now appears to have large cash reserves because it recorded its income from sales but has not recorded its future payment to its suppliers.

The primary difference between accrued expenses and prepaid expenses is the timing of the payment the business makes.

With an accrued expense, the business completes a purchase from its supplier but defers payment to a later date⁠ — It accrues expenses that it must make in the future. A household example of this is a credit card payment. You can swipe your card to buy lunch today and pay your credit card bill next month.

With a prepaid expense, the company pays its supplier before the transaction completes rather than after. A household example of this is using a prepaid phone ⁠— You pay the bill before receiving the service.

In the world of loans and bonds, accrual happens with interest rather than revenue or expenses.

Most bonds pay interest only in set intervals, typically every six or 12 months. However, interest usually compounds more often than that. In the time between each interest payment is made, interest accrues. When the payment date arrives, all accrued interest is paid to the bondholder.

Knowing the rate at which interest accrues lets bond sellers price their bonds accurately. If a bondholder sells a bond the day before its payment date, they won’t receive any payment. So, when pricing the bond for sale, they should add the accrued interest to the bond’s price to account for the interest that accrued while they owned the bond.

Likewise, when a business borrows money, knowing the rate at which interest accrues on the loan is essential for proper accounting. For example, if a company takes out a loan on December 20th, with the first payment due on January 20th, it will only make its first interest payment in the new year. However, because interest accrues daily, the company must account for the interest that accrued between December 20th and December 31st when determining its interest expenses for the year.

Businesses that sell goods on credit need to track accrued interest for a similar reason. They must record interest income when that interest accrues on its customers’ debts instead of when the customers make payments.

Though no cash changes hands, accruals reflect a future exchange of money, meaning that businesses must report them on their balance sheets.

If you have accrued expenses, the debt owing for them typically shows up on balance sheets under current liabilities. Businesses must pay most accrued expenses in the immediate future, though some could be longer-term. Any accrued expenses that will not be paid within a year show up as a long-term liability.

If revenue is accrued, the offset is unbilled revenue on the balance sheet. Unbilled revenue is a current asset because the business expects to receive cash in the near future and can expect to use that cash for purchases or other necessary payments.

Accruals can also be made in other balance sheet accounts, including:

• Accounts payable
• Accounts receivable
• Goodwill
• Future tax liability
• Future interest expenses

An accrued expense is not an asset — It is an expense that a business hasn’t paid yet, which is a liability.

Prepaid expenses are assets because they represent money that the business has already spent on a good or service in advance of using it. As the prepaid expenses are used, the business reduces the prepaid expense potion of its current assets and records an expense.