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Accruals - Realize and Recognize

In an accrual method of accounting transactions or portion of transactions are recorded to the period that they belong to.


This is done to accurately reflect the use of company's resources.


Example:


In September XYZ company sells $100 worth of goods and delivers. However, the sale is done on credit and the payment will only come in October.


Under cash accounting that small companies use, they will record the sale in October. However, under accrual method we would realize the sale in September and record revenue and the cost of good sold. We would also increase our assets in September by recording increase in accounts receivable. In October, when the payment comes, we would decrease account receivable and increase cash.


Recognize: A transaction gets recognized when not all criteria is met to realize it. In the example above, what if we got the payment in September but did not deliver the product until October? In that case we would recognize accrued revenue under unearned revenue in September. We would not make any other entries.


Realize: A realization happens when a transaction is complete. If we got payment in September and delivered in October, we would realize revenue and the cost of goods sold in October when the product is delivered.


Example:


One of the most common example of accruals is payroll.


Company XYZ pays payroll every 2 weeks. This payroll period ends at the end of week 2 and that is when employees will get paid. Week 1 in this period belonged to September, Week 2 belonged to October. All employees worked equally and 2 week pay rate is $40,000.


Under cash method in October the entry is:


Dr. Payroll Expense $40,000

Cr. Cash $40,000


Under accrual method in September the entry is:


Dr. Payroll Expense $20,000 (To realize portion of work performed in September)

Cr. Payroll Payable $20,000


Under accrual method in October the entry is:


Dr. Payroll Payable $20,000

Dr. Payroll Expense $20,000

Cr. Cash $40,000


The benefit of accrual method is you can see accurately what has financially transpired in a given period. Financial analysis are then possible. Under cash method, financial picture is distorted as it simply counts when checks are cleared and payments are made.