Accounting for Accruals
This Covers: Accruals, Supplier Invoices, Costs, Trade Creditors, Payments
1. Understand: WHAT is an Accrual?
An accrual is an accounting entry that brings a cost into the Accounts in advance of receiving an actual invoice or bill from the supplier. You accrue or anticipate the cost.
The other side of the entry creates a liability (an amount owed) on the Balance Sheet.
So the basic double entry is:
When the actual invoice is received it effectively replaces the Accrual with a Trade Creditor (ie. a named supplier) - in the Purchase Ledger.
Accrual accounting adheres to the fundamental accounting principle of matching - ie. costs are accounted for at the time they are incurred rather than when any cash changes hands.
Matching ensures that the Accounts give a true and fair view of economic activity over the accounting period.
A common example of accruals is Energy Costs - where usage is billed in arrears. Think of your own household bills - you consume energy through the year but may only pay quarterly. So in any one month how much does energy actually COST you?
Accruals can be generated from 2 sources:
• Accruals can often based on estimates. (Note: Where the actual invoiced amount differs from the accrual the Profit and Loss account will be impacted by the difference. So accuracy in estimating accruals is key to reducing risk in reported results. (see June in the example below).)
• Accruals are often posted as Reversing Journals (ie. they automatically reverse back out in the next accounting period (see *Notes below )).
• Accrual postings are generated at month end as part of the accounting period close process.
Zelda: Zombie Slayer operates a slaying business - ZZS.
Slaying is energy intensive!
ZZS is billed every 2 months in arrears for energy usage by supplier Energetic.
Based on prior rates of slay Zelda estimates to be billed £1000 for the two months to end of May.
In June Energetic actually bills ZZS £1,200 for the 2 months, after a particularly messy Zombie apocalypse in May.
1. Show the double entry accounting entries for the energy transactions.
2. Show the Ledger Balances at end of April May and June.
Total accrual over 2 months = £1,000. Therefore charge for each month = £500.
So you can see that the supplier Invoice takes the place of the accrual estimate in June and the difference of £200 adversely impacts the reported profit in that month (even though there ws no actual usage in that month - just a correction of an estimate).
Calculating and controlling Accruals is often managed offline via a Spreadsheet. A manual journal is then raised at month end.
IMPORTANT: accrual journals are usually posted as Reversing Journals - ie. they automatically reverse in the next period. This reduces the chance of a fairly common error - double-posting of costs. This can happen because both the accrual and the subsequent invoice are posted to the same ledger account.
On the flip side, reversing journals cancel themselves out. The risk here is that if an accrual is not posted again in the next period - and no invoice is received - costs will be understated.
Lastly, VAT (or equivalent taxes): should you accrue or not? The rule here is ask yourself: what will be the actual cost to the organisation once the invoice comes in. If VAT is reclaimable, do not accrue the VAT. If it is retained as a cost, then accrue.
One of our missions here at the Alternative Accountant is to provide simple, practical worked examples of double entry accounting across a range of real life Accounting Scenarios.
The reality of Accounting is that however sophisticated finance systems and ERP systems purport to be, the basic, simple principles of double entry accounting must - and will - always hold true.
What's more, these systems are only as good as the integrity of the processes and controls feeding them with data. As anyone who works in accounting knows, processes ALWAYS break down at some point!
A good grounding in double entry principles and mechanics is essential to understand and resolve the resulting issues and risks efficiently and correctly.