How to correctly calculate, report, and reverse accruals on the balance sheet

As an en­tre­pre­neur, you are obligated to file your taxes with the Internal Revenue System (IRS). This can be made a lot easier by using the double-entry book­keep­ing system and by keeping your records as detailed as possible. A complete balance sheet involves correctly reporting accruals and reversing them if required. But what exactly are accruals in ac­count­ing and how are they cal­cu­lat­ed, recorded on the balance sheet, and reversed? We’ll explain the steps you need to take for accurate booking entries.

Accruals are expenses or revenues incurred in a period for which no invoice was sent or no money changed hands. If for example, you’re in an ongoing court case, you can assume that legal fees will need to be paid in the near future and not straight­away so you have to factor that into your cal­cu­la­tions. It could even be that the process spills over into the next calendar year. Since accruals are amounts that are un­ac­count­ed for that your business still owes at the end of the ac­count­ing period, you simply estimate the accruals and the figure should then cor­re­spond to the future legal costs. As soon as the legal fees have been paid, you can reverse the accrual on the balance sheet. Pro­vi­sions are similar to accruals and are allocated toward probable, however, not yet certain, future oblig­a­tions. An accrual is where there is more certainty that an expense will be incurred.

Accrual ac­count­ing differs from cash ac­count­ing in that revenue and expenses are recorded when the service is performed or when the expense is incurred re­gard­less of when the cash is received or paid. This video explains the dif­fer­ence between the two in more details:

Accrual ac­count­ing is also more common and is preferred by the IRS if the company has more than a certain level of revenue or carry inventory. Here is an example of how accrual ac­count­ing works:

Company X has insured one of its buildings and gets billed for this service twice a year ($500 each time). Using the cash ac­count­ing method, Company X would record $500 twice a year but the accrual ac­count­ing method would mean that the company would divide the whole amount for the year ($1000) between twelve months, which would mean paying around $83 per month.

There are two reasons why accruals are used:

• If the company has already taken benefits but hasn’t yet paid
• If services have been provided but the company has not yet been paid

By using accruals, a business can see beyond its cash flow and be able to plan better. It’s normal for a company to record trans­ac­tions where cash changes hands but trans­ac­tions aren’t always like this. For example, an airline will receive payment weeks or months in advance as most people book their flights quite a bit in advance of the actual flight. This means that the airline has received payment but the service still needs to be delivered. An example that shows the opposite is an appliance store that lets customers buy on credit so they receive their washing machine straight away but don’t have to pay during the first year, meaning the company knows it can expect money after the first year has passed.

When a company records an amount as an accrual, it helps them to have a better overview of their financial situation so they know what they still owe or what is owed to them.

Although there are many kinds of accruals, most of them fall into one of the two cat­e­gories:

• Expense: when a company has received services and goods but it hasn’t made a payment yet. An example is a company receiving an elec­tric­i­ty bill in March for the last few months’ elec­tric­i­ty usage. The business would record this as an expense accrual.

• Revenue: when a company has provided goods or services but payment hasn’t yet been received. For example, when a customer buys a vehicle on credit and pays later. The company knows that it will have the money coming in at a certain point in time.

When you reverse accruals, you’re canceling the prior month’s accruals. Accrual ac­count­ing matches revenue and expenses to the current ac­count­ing period so that every­thing is even. Accruals will continue to build up until a cor­re­spond­ing entry is made, which then balances out the amount. By reversing accruals, it means that if there is an accrual error, you don’t have to make adjusting entries because the original entry is canceled when the next ac­count­ing period starts. Despite this, reversing accruals are optional or can be used at any time since they don’t make a dif­fer­ence to the financial statement. They can be used to match revenues, expenses, and prepaid items to the current ac­count­ing period—but cannot be made for reversing de­pre­ci­a­tion or debt. Reversing accruals can either be made au­to­mat­i­cal­ly or manually. Manually would mean that entries are made on the first day of the month. An automatic system would mean that the entry is au­to­mat­i­cal­ly reversed on the first day of the next ac­count­ing period. Reversing accruals are very ad­van­ta­geous for large companies since they lessen the risk of double booking entries and save time because prior accrual history doesn’t need to be re­searched. It’s easy to keep an overview and complete the task without ac­count­ing knowledge since all it entails is canceling previous entries. Click here for important legal dis­claimers.