AccrualsPrerequisitesPrior to reading the standard Accruals, it is beneficial to review the sections below to gain foundational information: Show
PrefaceThis section discusses a general understanding of accruals, how they impact the income statement and balance sheet, and how they are recorded within Indiana University. The information below walks through accruals, accrual accounting and why it is important. The section will also discuss the impact of the matching principle on recording accruals. Lastly, this section will specify IU’s requirements and best practices associated with posting accruals. IntroductionUnderstanding Accrual vs. Cash Basis of AccountingThere are two main methods of accounting, accrual method and cash basis method. Indiana University is required to follow the accrual method of accounting under US GAAP. Accrual accounting attempts to match the revenues an entity has earned in a period with the expenses that were incurred to generate the revenue. Simply put, if the revenue is earned in June, it is recorded to the income statement in June, regardless of when the entity received payment from the customer. This method differs from the cash basis method which records revenues and expenses only when monies are exchanged. To illustrate the differences in these accounting methods, let’s review the following scenarios: Scenario 1: On January 1, you sign a lease to rent space in a building. The monthly rental payment is $50,000/month but you decide to pay the rent for the entire year upfront for a total of $600,000. Cash Basis - You would record this expense on 1/1, when you paid the $600,000. Accounting Entry on 1/1:
Accrual Basis - You would record a prepaid expense in the month you paid the fee (i.e. $600,000) and then you would recognize a $50,000 expense for each subsequent month you use the building. Accounting Entry on 1/1:
Recognition of the $50,000 of rent expense on 1/31:
Scenario 2: On January 1, you agree to perform consulting services for a client to be completed over the next two years. Each month you agree to perform $30,000 of work on the client’s behalf. The client signs the fee agreement and pays you $720,000. Cash Basis - You would record the revenue on 1/1, when you received the cash from the customer. Accounting entry on 1/1:
Accrual Basis - You would record unearned revenue in the month you received the fees and then you would recognize the revenue when you actually perform the services for the client. Accounting entry on 1/1:
Recognition of the $30,000 consulting services on 1/31:
Accrual Adjusting EntriesAn accrual refers to an entry made in the books of accounts related to the recording of revenue or expense paid without any exchange of cash. In order to comply with the accrual method, an accountant posts an accrual adjusting entry for revenue that has been earned but is not yet recorded and expenses that have been incurred but are also not yet recorded into the general ledger. Note, accruals impact both the income statement and the balance sheet. Accruals are made via journal entries at the end of each accounting period, which within IU is done using an accrual auxiliary voucher document. They are done at the end of an accounting period so that the reported income statement and balance sheet can be inclusive of these amounts. There are many types of accruals, but most fall under one of the two main types: revenue accruals and expense accruals.
Importance and Impact of AccrualsAccrual analysis is an important process because it helps fiscal officers and top management gauge levels of economic standing and ensure balances are in line with budgets by ensuring revenues and expenses are recorded in the correct period. Accruals allow an entity to better determine the profitability for the period, since revenues and related expenses are matched in the same period. The principle that allows for expenses incurred during a period to be recorded in the same period in which the related revenues are earned is known as the matching principle. The matching principle is used to accurately record expenses within an accounting period. The proper recognition of expenses is important because it impacts how revenue is recorded. Under the matching principle, expenses and revenues that are related to one another should be recorded in the same period. Recognizing the expenses in the incorrect period will distort the financial statements and provide an inaccurate financial position of the entity. To summarize, main reasons for completing accrual adjusting entries are:
Recording of AccrualsAccrual adjusting entries are entered manually into KFS via an auxiliary voucher accrual adjusting entry (AVAE). See Requirements and Best Practices for IU specific details. Examples of when to use this document include the accrual of revenues earned but not yet received, or recording expenses incurred, but not yet paid. This allows the entity to reflect the amount of revenue or expense incurred in the proper fiscal period and allows the matching of income with expenses. These entries automatically reverse in a subsequent period on a specified future date. The AVAE reversal date defaults to the 15th day of the month following the transaction posting; however, this date can be changed by the document creator if desired. For an example and more information of how an auxiliary voucher works, please see Training documentation. There are system generated and non-system generated accruals within IU. Since the university operates on the accrual basis, several of the material accruals are generated by the Enterprise Wide Systems (i.e. HRSM, Buy.IU and KFS). Examples of system generated accruals are included below. System-Generated AccrualsHRMS
BUY.IU
SIS
KFS
Non-System Generated AccrualsNon-system generated accruals are accruals that are calculated and entered manually by the user when the period ends. These need to be calculated and entered manually into the system. For further information on use of non-system generated accruals reach out to the local campus and fiscal officer. Requirements and Best PracticesIn order to ensure the accuracy of the university and unit level (internal) financial statements, it is important that each entity follows the accrual accounting method and adjusts its accruals periodically. This section outlines requirements related to the Closing Procedures - Accruals, as well as best practices. While not required, the best practices outlined below allow users to gain a better picture of the entity’s financial health and help identify potential issues on a more frequent basis. This allows organizations to identify errors, mistakes and pitfalls which can be remedied quickly and prevent larger issues in the future. RequirementsQuarterly Activities:
Best Practices
How does the adjusting entry for accrued interest impact the balance sheet?How does accrued interest affect the balance sheet? The accrued interest for the borrower is a credit to the accrued liabilities account and a debit to the interest expense account. The balance sheet considers this a short-term liability because it's to be paid within a short period, usually a year.
How do accruals impact the balance sheet and the income statement?Accruals are revenues earned or expenses incurred which impact a company's net income on the income statement, although cash related to the transaction has not yet changed hands. Accruals also affect the balance sheet, as they involve non-cash assets and liabilities.
How do accrued expenses affect the balance sheet?Accrued expense. When expenses are accrued, this means that an accrued liabilities account is increased, while the amount of the expense reduces the retained earnings account. Thus, the liability portion of the balance sheet increases, while the equity portion declines.
How does accrual expenses affect financial statements?Accrued expenses are the expenses that companies have incurred but not yet paid for, which can still affect a company's income statement. However, an accrued expense in itself is a liability account on the balance sheet, and paying off the liability later doesn't affect a company's income statement.
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