The accruals concept is also called the ‘matching concept’ because it involves making sure that you ‘match’ transactions to the period that they relate to. For example, if I make a sale in December but don’t actually get paid until January, I will account for the revenue when the sale was actually made…in December. When I get paid for the sale is irrelevant to when I recognise the income.
Applying the accruals concept to expenses
When working out the expenses figure to be recognised in the profit and loss account, the key thing is to ensure that you are recognising the correct number of months of expense. In a three-month accounting period we need to recognise 3 months of expense. In a twelve-month accounting period we need to recognise 12 months of expense.
Setting up an accrual
Let’s say a business started on the 1st January 2015 and has a year-end of 31st The first accounting period is therefore 12 months long. Let’s say that during this year the business received three £300 telephone bills, each covering a 3-month period (so £100 per month). By 31st December 2015 they would have recognised 3 x £300 = £900 of telephone expense (this would be a debit in the telephone expense account). This is only 9 months of expense so we are not ‘matching’ enough expense to the 12 month accounting period. We are short by 3 months! The way we recognise the extra expense that is required is with an accrual. An accrual is a liability you owe to someone but haven’t actually been invoiced for yet.
The reason this often happens is that bills for many utilities are received ‘in arrears’ ie after the end of the period they relate to. Let’s say that the final £300 telephone bill of the year (covering October to December) is actually received in January 2016. Even though the bill is received in the following year we need to ‘match’ this cost to the period that it relates to which is the year ended 31st December 2015 as this is when the telephone was being used.
To set up the accrual the double entry is:
Debit – telephone expense £300, being added to the £900 already recognised
Credit – accrual £300, which is the liability owed to the telephone company
This means that the telephone expense for the year ended 31st December 2015 is now £900 + £300 = £1,200 which is a full and correct 12 months of expense.
Dealing with the accrual in the next accounting period
As the accrual account is a balance sheet item (it is a liability) it will be carried down at the start of the following period as a credit balance in the accruals ledger account. Since the invoice that we accrued for is now going to be actually received we need to ‘reverse’ the accrual back out of the accounts. We do this by posting exactly the reverse double entry used to set it up:
Debit – accrual £300 to get rid of it, as we will now receive and pay the bill
Credit – telephone expense £300, as the bill being paid actually relates to the prior year not this one. We are therefore cancelling the debit entry that would be posted to the telephone expense account for the bill being paid.
Why don’t you have a go at this example? When you have finished you can see me talk through my solution in the online video.
Following on from the explanations above the business receives the following telephone bills in the year ended 31st December 2016:
- In January – £300 for the period October to December 2015
- In April – £600 for the period January to March 2016
- In July – £600 for the period April to June 2016
- In October – £600 for the period July to September 2016
- They then receive a £600 telephone bill for the period October to December 2016 in January 2017.
- Show the telephone expense and accrual ledger accounts for the year ended 31st December 2016.