What Is Accruing?
To accrue means to accumulate over time, and is most commonly used when referring to the interest, income, or expenses of an individual or business. Interest in a savings account, for example, accrues so that over time, the total amount in that account grows. The term accrue is often related to the concepts of accrual accounting, which has become the standard accounting practice for most companies.
How Accruing Works
When something financial accrues, it essentially builds up to be paid or received in a future period. Both assets and liabilities can accrue over time. The term accrue, when related to finance, is synonymous with an "accrual" under the accounting method outlined by Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). An accrual is an accounting adjustment used to track and record revenues that have been earned but not received, or expenses that have been incurred but not paid. Think of accrued entries as the opposite of unearned entries; the corresponding financial event has already taken place but payment has not yet been made or received.
Accepted and mandatory accruals are decided by the Fair Accounting Standards Board (FASB), which controls interpretations of GAAP. Accruals can include accounts payable, accounts receivable, goodwill, future tax liability, and future interest expense.
An example: All Weather Construction orders $5,000 of lumber. It receives the lumber and uses it in the construction of a new house, prior to the receipt of the supplier’s invoice. The $5,000 is recorded on the construction company’s books as an accrued credit for accounts payable, and an accrued debit for supplies. Once the invoice for the lumber is received and paid, the transactions reverse, with a credit to supplies and debit to accounts payable.
Accrual Accounting vs. Cash Accounting
The accrual accounting procedure measures the performance and position of a company by recognizing economic events regardless of when cash transactions occur, giving a better picture of the company's financial health and causing asset or liability adjustments to build up over time. This is in contrast to the cash method of accounting where revenues and expenses are recorded when the funds are actually paid or received, leaving out revenue based on credit and future liabilities. Cash-based accounting does not need adjustments.
While some very small or new businesses use cash accounting, companies normally prefer the accrual accounting method. Accrual accounting gives a far better picture of a company’s financial situation than cost accounting does because it records not only the company’s current finances but also future transactions. If a company sold $100 worth of product on credit in January, for example, it would want to record that $100 in January under the accrual accounting method rather than wait until the cash is actually received, which may take months or may even become bad debt.
Types of Accounting Accruals
All accruals fall into one of two categories: either a revenue or expense accrual.
Revenue accruals represent income or assets (including non-cash-based ones) yet to be received: They occur when a good or service has been sold or rendered by a company, but the payment for it has not actually been made by the customer. Companies with large amounts of credit card transactions usually have high levels of accounts receivable and high levels of accrued revenue.
Assume that Company ABC hires Consulting Firm XYZ to help on a project that is estimated to take three months to complete. The fee for this job is $150,000, to be paid upon completion. While ABC owes XYZ $50,000 after each monthly milestone, the total fee accrues over the duration of the project instead of being paid in installments.
Whenever a business recognizes an expense before it is actually paid, it can make an accrual entry in its general ledger. The expense may also be listed as accrued in the balance sheet and charged against income in the income statement.
Expense accruals can vary. Common types include:
- Interest expense accruals are made by a company that owes monthly interest on debt prior to receiving the monthly invoice.
- Supplier accruals are made when a company receives a good or service from a third-party supplier on credit and plans to pay the supplier at a later date. This type of accrual is recorded under accounts payable and is considered an accrued operating expense.
- Wage or salary accruals are made by companies that pay employees prior to the end of the month for a full month of work.
Interest and tax payments sometimes need to be put into accrued entries whenever yet-unpaid interest and tax obligations should be recognized in the financial statements. Otherwise, the operating expenses for a certain period might be understated. This results in net income being overstated. Investors, lenders, and regulators do not receive a fair representation of the company's present financial condition if that occurs.
Salaries are accrued whenever a workweek does not neatly correspond with monthly financial reports and payroll. For example, a payroll date may fall on January 28. If employees have to work on January 29, 30 or 31, those workdays still count toward the January operating expenses. Current payroll has not yet accounted for those salary expenses, so an accrued salary account, or salaries payable, is created.
There are different rationales for accruing specific expenses. The general purpose of an accrual account is to match expenses with the accounting period during which they were incurred. Accrued expenses are also effective in predicting the amount of expenses the company can expect to see in the future.
Accrued Expenses vs. Prepaid Expenses
A prepaid expense is the opposite of an accrued expense. Instead of paying an expense after it's recorded in the books, expenses are paid for goods and services that will be received in the future. Say that Company ABC hires a lawyer for one year, which requires an upfront payment of $100,000; the company has not received services, so it cannot realize the expense yet. This is recorded as a type of asset on its balance sheet.
Accrued expenses are more accurate, accountants feel. Using accrued expenses instead of prepaid expenses gives a company a better depiction of its performance and operations, showing how much it is spending in a specified period.
For example, Company ABC usually receives goods from a supplier, which it can immediately resell for a profit. It is not required to pay for those goods for another three months. The company can generate revenues from the sales, so it is recorded as an accrued expense. Company XYZ, on the other hand, prepays a supplier for a year of goods, but the supplier delivers goods every three months. The goods have not been delivered yet, so the company needs to record this as a prepaid expense asset. XYZ must recognize its expenses every three months. This is a disadvantage; the company cannot see how well the goods are selling and has already paid for a year of goods.
Anyone who has ever made payments on a loan is familiar with the concept of accrued interest. After each payment is made, the remaining principal continues to accumulate interest. Accrued interest is simply the cumulative amount of interest earned on an investment since the last payment.
Assume ABC takes out a $20,000 loan with a 10% annual interest rate. Payments are due monthly. At the end of the first month, the amount of interest accrued by this loan is $20,000 x .10 ÷ 12, or $167. For the lender, this $167 is income that is due but has not yet been received. For ABC, it counts as a debt that needs to be paid.
Accrued Bond Interest
As with a loan, interest accrues daily on bonds. So when a bond is sold in the secondary market before the scheduled payment, the seller and buyer must split the next interest payment. When making this transaction through a broker-dealer, the accrued interest is worked into the gross price per bond, with the amount of accrued interest due to the seller listed.
The accrued interest can be calculated by first finding the daily rate, which is determined using a 30-day month and 360-day year, and then multiplying by the number of days remaining before the next coupon date. For example, for a bond with an interest rate of 5% paying semi-annually, each payment is equal to $25, or $50 annually. If the buyer is purchasing the bond on May 1 and the interest payment is due June 1, the accrued interest is calculated as follows: ($1,000 x 5%) x (122 ÷ 360) = $16.94. Because interest accrues through the day before the settlement date, 122 days are used.
The accrued interest in this scenario is owed to the seller once the payment is received by the buyer. To accommodate this, the price the buyer pays is adjusted. In essence, the seller receives his accrued interest at the time of sale from the buyer, who receives the whole interest payment on June 1. If this were not the case, buyers could buy up bonds with accrued interest the day before the payment date and collect the full interest payment, which is unfair to the seller.