How Accrual Accounting Work

By: First Union | Date:

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How Accrual Accounting Work

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The term "accrued" in business is directly related to one of how accounting is done, among other aspects of a business. A very popular method of accounting, the accrual approach counts payments and debts at the time of the transaction, not necessarily when actual money is exchanged. In this article, we take a closer look at accrual accounting in business and along with some types of business transactions that can "accrue."

The word accrual itself refers to the accumulation of something. Within the context of the business world, this could point to a variety of things, money for instance as well as accrued sick days. Benefits can accrue over a given period and thereby be disbursed all at once or little by little. The debt of course is something else that tends to accrue. The interest on that debt as well will certainly accrue the larger that debt becomes. It is key for any business owner to keep track of all relevant accruals—not just how their accounting is handled.

Accrual Accounting

There are two approaches to accounting in business. The cash accounting system and the accrual accounting method. With a cash system, the income and expenses are accounted for when the money changes hands. Which type of method a business chooses is up to them and is often tied to their industry and business model.

The system of accounting you choose will also directly impact taxes since the timing of revenue is going to be important as far as the income tax that you will pay for a given year. Again, in cash accounting, the payments and expenses are recorded upon the actual money being received and/or paid out.

With an accrual-based system, how transactions get recorded is a bit different. The money does not need to change hands for the business to record that transaction. Rather, the payments and expenses are recorded at the time the customer is billed. So for example, the company will send the invoice and even though the customer has yet to submit payment, the sale still goes into the books at that time. Same with expenses. The business receives a bill and that gets immediately recorded as an expense even though they have yet to remit payment on that invoice. The transactions with accruals accounting are based upon the transaction itself, not the monetary execution connected with that transaction.

Why utilize accrual accounting versus cash accounting? For many businesses, accrual accounting represents an easier way to maintain their books. Let's say you had a large sale for which you billed the client in November; by February however, they've yet to pay the invoice. You can still count that sale using the accrual accounting method for the year during which the transaction took place without having to wait for the money to come in. This, for many, is a cleaner and more streamlined way of keeping track of their income and expenses. If a business has inventory, they almost will always use the accrual accounting method; in some instances, they may be required to.

Other Kinds of Accruals

Interest

The concept of accrued interest in accounting also works in a couple of different ways. Interest can accumulate and benefit the business, and then there is also accrued interest on a debt. For example, a bond will earn interest over time, and every six months that interest gets paid out. The interest will then begin to accrue again. The same goes for any interest-bearing accounts that you may have for your business. Interest will accrue over time and at specific points that money will be paid out to you.

On the other hand, there is accrued interest on any loans the company may have. So if you do have some form of commercial financing in place, depending on your terms, the interest gets added regularly—this is the accrued interest. Upon making a payment, you are paying down both principal and interest and this, in turn, decreases the total of accrued interest on the loan.

Liabilities

There are also accrued liabilities. These are also known as payables in accounting. Among the more common forms of payables are payroll tax and sales tax. These are accounts that you must pay to avoid any penalties or fines down the road.

With sales tax, for example, the company will have to collect sales tax on all taxable items sold. When that transaction is recorded, the sales tax gets noted separately. This is your sales tax payable. Such taxes ultimately accrue over time until the point at which you pay them to your state's tax authority. Once the sales taxes are paid, you will effectively zero out that account and start again.

Payroll Taxes

Payroll taxes work much the same as sales tax. That is to say, from your employees' paychecks you will withhold a certain amount for federal and state income taxes. You will thus set up a payable account for these taxes and consequently remit the money to the relevant federalstate entities.

Benefits

Another among the more common accruals is paid time off. Vacation time for instance is an employee benefit that accrues over months or years. Vacation time is generally based on several factors to include years of service and your company's overall policies regarding paid time off. An employee accrues vacation days and then can usually opt to take them however they choose, pending company policy.

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