How Accruals Work in Business
The term "accrued" is important in business and accounting, and knowing how accrued accounts work will come in handy as you manage your small business.
What Does Accrued Mean?
The word accrued is an adjective, describing something that accumulates over time. In the case of a business, accruals are often money, but time can also be accrued, as in paid time off. Accruals work in two ways:
- Benefits, as in money or time, can accrue to someone. These benefits can be received or increase over time.
- Obligations and debt can also accrue. The debt gets larger over time, like over the term of a loan. Accrued interest (explained below) is an example of how this happens.
Yes, in business everything builds up, both on the credit side and the debit side; it's just part of the accounting system. Understanding accrued accounts in your business is important for you as a business owner.
How Accrual Accounting Works
The opposite of an accrual system is a cash system, payments, and receipts that are accounted for when received. A cash system is tied to cash flow.
Business can operate on either type of system. You have a choice of running your business under either cash accounting or accrual accounting. The difference is important because the accounting method you select affects the timing of revenue and expenses, and it can affect the amount of income tax your business pays in a year.
In cash accounting, you record income and expenses when the money is received or paid.
In accrual accounting, you record the income and expenses when a transaction is complete, not when money changes hands. You record a sale when you bill the customer (give them an invoice) to show that the transaction is complete, not when you get paid. You record an expense when you receive the bill, not when you pay it. In each case, you are accounting for the transaction when it was earned.
Small Business expert Susan Ward says that accrual accounting can make it easier to manage your business and match revenue and expenses. For example, if you billed a large client in December but you didn't receive the money until March, accrual accounting would allow you to record the sale in December, in the same year as the work was done and the expenses for that work were recorded.
Businesses with inventory have been required to use the accrual accounting method, but the 2017 tax law allows more small businesses to use cash accounting.
Other Examples of Accrued Accounts
Accrued interest is one of those accounting concepts that can work two ways - accumulating interest to your benefit vs. accruing interest to your debt.
Bonds earn interest on a regular basis, but that interest is only paid out every six months, so the interest accrues between one payment and the next. When you buy a bond you receive the market value plus the accrued interest up to the settlement date. If you have interest-bearing accounts in your business (like a money-market account), that interest accrues in the same way.
Loans you have taken out (a startup loan, for example) also have accrued interest, which is added regularly. When you make a payment, you are paying both principal and interest, which reduces accrued interest.
Liabilities in Accounting
Accrued liabilities are those that you owe in the future or that are unpaid. The accounting term is Payables. The two most common payables are sales taxes and payroll taxes; these are called trust fund taxes because you take them in trust. Let's take sales taxes since we'll be talking about payroll taxes below.
These trust fund accounts are not the property of your business. Leaving them unpaid and using this money to pay business bills can result in stiff fines and penalties.
Your business collects sales taxes on taxable items. When each sales transaction is put into your accounting system, the tax is recorded separately and it's put into an account called "Sales Taxes Payable." These taxes accrue (build up) in that account until you pay them to your state's taxing authority. The Sales Taxes Payable account goes to zero and you start accumulating all over again.
Accrued Liabilities in Payroll and Benefits
In the same way as for sale taxes, amounts you withhold from employee paychecks for federal and state income taxes, FICA taxes (Social Security/Medicare), and other benefits must be kept separate. Payable accounts need to be set up for Federal Income Taxes Payable, FICA Payable, etc.)
Time Off Benefits
Paid vacation benefits are a good example of how an employee benefit is accrued. Usually, vacation time is accrued (earned) each year based on the employee's length of service and your employee policies. Let's say Carlos earns 1.5 days a month, so at the end of a year, he has accrued 18 vacation days. As he takes vacation days, Carlos' accrued vacation is reduced.