Bonus Accrual
A bonus accrual is an accounting practice used by companies to estimate and set aside funds for employee bonuses that will be paid out in the future. Bonuses are typically paid to employees based on their performance, the achievement of specific targets, or company-wide profitability. The accrual method ensures that the expense related to these bonuses is recognized in the same accounting period when the related revenue or performance is achieved, adhering to the accrual accounting principle of matching revenues and expenses.
Here’s how the bonus accrual process works:
- Estimate the bonus amount: The company estimates the total bonus amount that will be paid to employees based on their performance, the achievement of specific targets, or company-wide profitability. This estimation is typically based on historical data, current performance trends, or established bonus plans.
- Record the bonus accrual: The company records the estimated bonus amount as a liability on its balance sheet, typically under “Accrued Liabilities” or “Accrued Expenses.” Simultaneously, the company records an expense in the income statement, usually under “Salaries and Wages” or a separate “Bonus Expense” line item. This accounting entry ensures that the bonus expense is recognized in the same period when the related revenue or performance is achieved.
- Adjust the bonus accrual: At the end of the accounting period or when the actual bonus amounts are determined, the company adjusts the bonus accrual to reflect the actual bonus payments. If the actual bonus amount is higher than the estimated amount, the company will increase the bonus accrual and expense; if the actual bonus amount is lower than the estimated amount, the company will decrease the bonus accrual and expense.
- Pay the bonuses: When the company pays out the bonuses to employees, it reduces the accrued liability on the balance sheet and the cash account.
In summary, a bonus accrual is an accounting practice used by companies to estimate and set aside funds for employee bonuses, ensuring that the expense is recognized in the same accounting period when the related revenue or performance is achieved. This process adheres to the accrual accounting principle of matching revenues and expenses, providing a more accurate representation of the company’s financial performance.
Example of a Bonus Accrual
Let’s consider a hypothetical example of a company using the bonus accrual method.
Company XYZ has a fiscal year-end on December 31st. It has a performance-based bonus plan for its employees, where bonuses are paid in the first quarter of the following year, based on the previous year’s performance. To ensure that the bonus expense is recognized in the same accounting period when the related revenue or performance is achieved, the company uses the bonus accrual method.
Here’s how the process works for Company XYZ:
- Estimate the bonus amount: Based on the company’s performance and historical data, Company XYZ estimates that it will pay out a total of $100,000 in employee bonuses for the year.
- Record the bonus accrual: At the end of each month, Company XYZ records a bonus accrual of $8,333 ($100,000 ÷ 12 months) as a liability on its balance sheet under “Accrued Liabilities” or “Accrued Expenses.” Simultaneously, the company records an expense in the income statement, usually under “Salaries and Wages” or a separate “Bonus Expense” line item.
- Adjust the bonus accrual: In February of the following year, Company XYZ finalizes the actual bonus amounts to be paid to employees, totaling $95,000. The company adjusts the bonus accrual by reducing the liability by $5,000 ($100,000 estimated bonus – $95,000 actual bonus) and decreasing the bonus expense by the same amount.
- Pay the bonuses: When Company XYZ pays out the $95,000 in bonuses to its employees, it reduces the accrued liability on the balance sheet by $95,000 and the cash account by the same amount.
In this example, the bonus accrual method allows Company XYZ to recognize the bonus expense in the same accounting period when the related revenue or performance is achieved, adhering to the accrual accounting principle of matching revenues and expenses. This provides a more accurate representation of the company’s financial performance and ensures that the company sets aside the necessary funds for employee bonuses.