Accrual principle is associated with the matching principle where we record the expenses in the period it is incurred.
Accrual accounting is widely used method when recognizing revenues and expenses. On the other hand, there is also the Cash basis accounting, where revenue and expenses are recognized when cash is received or paid.
Recording accruals requires making reasonable estimates using historical information we have. We can also use the actual invoices on hand that is not yet entered into our books as of month end.
Let us say that the company received a bill for its electricity expense this September, the billing is for the month of August. At end of August, since we do not have the invoice, we therefore need to make an estimate and book an accrual of this expense.
In making estimates, we can average the monthly expenses. Let us say, the average monthly electric charges is $1200; then with supporting documentation we can book our August electricity even without the invoice. We are then able to match the expense in period they are incurred.
Most companies however adapt recording of accruals as a reversing entry; in this way, we no longer need to monitor the difference in the amount we accrued and the actual expense.
What is a reversing entry? It means that the the journal entry will be reversed at the beginning of next month. In this example, it is September 1.
What is the purpose of reversing entries? So we do not need to monitor the difference in the amount we accrued and the actual expense.
In this example, when the August bill is received and paid in September 5 with actual expense of $1280 will be booked as follows:
Without making the reversing entry in Sept 1, actual August invoice paid in September 5 should be recorded as
As you can see, recording a reversal entry is more convenient. In the entry above, you will need to check how much was accrued for the particular invoice to close the liability amount of $1200. This method, is more prone to errors compared to opting to record reversing entries.
The
$80 difference is due to our
under accrual of August expense. Accruals should be based on
reasonable estimates to prevent material over or under accrual. The key here is that, any under or over accrual should be- immaterial when it comes to financial reporting.
Let us look at the Utilities Expense, the reported expense is the same for both method.
Adding to the example that September billing has not been received and is accrued for $1300.
What if your August invoice is still unavailable by September.
Accrual with reversing entry: You will need to re-accrue your August utility expense at Sept 30 which should also reverse in Oct 1. This is because without the actual invoice, and with the Sept 1 reversing entry, you will get a negative Utility Expense for September; therefore you will need to re-accrue.
It is likely that you do not have the September billing as well. Then you will need to accrue both August and September.
Accrual with no reversing entry - No need to re-accrue your August utility expense. It is likely that you do not have the September billing as well. Then you will need to accrue only the September expense.
