Accruals

Accruals are revenues and expenses that are recognized (usually referred to as “accrued”) prior to the due date for their receipt or payment as the case may be. This practice of accruing revenues and expenses before their due dates is based on the accrual principle of accounting.

Accrual concept states that transactions need to be recognized in the period to which they relate rather than in the period in which the payments are made. For example, utility bills of December 20X5 must be reflected in year ended December 31, 20X5’s financial statements even if the bills are received in January 20X6.

Since the receipt of accrued revenues and the payment of accrued expenses happen at a later date, accrued revenues are always accompanied by accrued accounts receivable; and accrued expenses by accrued liabilities. These assets and liabilities are typically short-term i.e. current assets and current liabilities.

Journal Entries

Accounting for accrual of revenues involves the following journal entries:

  1. Adjusting entries at the end of the each accounting period to debit accrued accounts receivable and credit revenue.
  2. Journal entries to record the receipt of revenue on receipt date involve a debit to cash or bank and credits to accounts receivable for the accumulated revenue accrued and to revenue for the any additional accrual during the accounting period.

Similarly, accounting for accrual of expenses involve the following entries:

  1. Adjusting entries at the end of each accounting period to debit the accrued expense account and credit a relevant accrued liability account.
  2. Journal entries to record the payment of expense on payment date involve debits to expense account and relevant accrued liability account; and a credit to cash or bank account.

Example

On Jul 1, 20X4, Company A obtained a loan of $50,000 for five years at interest rate of 8% per annum from Company B. The interest is payable on yearly basis on June 30 each year. The principle is payable at the end of the 5 year period. Both companies close their accounts on Dec 31 each year.

Required: Journal entries in both companies’ accounts on Dec 31, 20X4 and Jun 30, 20X5.

Solution

On Dec 31, 20X4:

Company A’s Accounts: To accrue interest expense on loan:

Interest Expense [=$50,000×0.08×6/12]2,000
Accrued Interest2,000

Company B’s Accounts: To accrue interest earned on loan:

Interest Receivable [=$50,000×0.08×6/12]2,000
Interest Income2,000

On Jun 30, 20X5:

Company A’s Accounts: To record payment of interest on loan:

Interest Expense [=$50,000×0.08×6/12]2,000
Accrued Interest2,000
Cash at Bank4,000

Company B’s Accounts: To record receipt of interest on loan:

Cash at Bank4,000
Interest Income2,000
Interest Receivable2,000

Written by Irfanullah Jan