Accruals

Accrue refers to the gradual accumulation of something over time, typically in financial matters, such as interest, income, or expenses. In accounting and finance, accruals are recorded when revenue or expenses are earned or incurred, regardless of when the actual cash transaction takes place. This concept is crucial for reflecting a more accurate financial position at a given time, especially when financial statements are prepared.

How accrual works

In financial terms, accruals are recorded based on when an event occurs, not when the cash is exchanged. For example, interest on a loan accrues daily or monthly, even if the borrower only makes repayments annually. This means that despite no payment, the interest is added to the amount owed, which grows over time.

Types of accruals

• Accrued income: Income that has been earned but not yet received. For example, a business may have provided a service to a client but has not yet been paid. The income is recognised as accrued income until the payment is made.
• Accrued expenses: Expenses that have been incurred but not yet paid. For instance, a business might owe wages to employees for work done in the current period, but the payment will be made in the following period.
• Accrued interest: Interest that builds up over time on a loan or investment may not be paid until a future date. Accrued interest is common in loans, savings accounts, and bonds.

Importance of accruals in accounting

Accurate financial reporting

Accrual accounting ensures that income and expenses are recorded in the period in which they are earned or incurred rather than when cash is exchanged. This provides a more accurate and consistent view of a company’s financial position, making it easier for stakeholders to assess performance.

Matching principle

Accrual accounting is based on the matching principle, which states that expenses should be recognised in the same period as the revenues they help generate. For example, if a business incurs costs to deliver a product in December but doesn’t get paid until January, those expenses should still be recorded in December to match the related revenue.

Cash flow management

Accruals help businesses manage cash flow by recognising future payments or income. By tracking accrued expenses and income, companies can better plan for upcoming financial obligations and make informed decisions regarding their cash reserves.

Accrue in action

Example: Accrued interest on a loan

A borrower takes out a loan with a 5% annual interest rate. Even if the loan repayments are only due once a year, the interest accrues daily or monthly. At the end of each month, the interest owed is added to the total amount of the loan, even though the borrower hasn’t made any payments. The total interest owed will continue to accrue until the repayment is made.

Benefits of accruing interest or income

• Better financial planning: Accrued interest allows borrowers and investors to plan their payments or returns by understanding how much will be owed or earned over time.
• More accurate financial statements: For businesses, recording accrued income and expenses helps provide a more accurate snapshot of the company’s financial health.

Risks of accruals

• Complexity in management: Accruing income and expenses can add complexity to financial reporting, requiring careful tracking to ensure the books remain balanced.
• Potential cash flow issues: While accruals help in reporting, they do not reflect actual cash in hand. A business may show a profit based on accruals, but if actual payments are delayed, it could face cash flow shortages.

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Accruals are critical in managing your finances, from understanding interest growth to planning for future expenses. At Funding, we offer tailored financial solutions to help you navigate the complexities of accruals in real estate and business investments.

Learn more

Financial confidence comes with learning. Explore our Learning Centre and read these helpful links:

• Understanding how property investment can build your wealth
• How to improve your credit score before applying for a loan