Under accrual refers to the situation where a company has recorded less in accruals than what it actually incurred in expenses or earned in revenues during an accounting period. Accrual accounting recognizes economic events as they are incurred or earned, regardless of the timing of cash exchanges. When a company under-accrues, it understates its expenses or revenues, which can lead to inaccurate financial statements and potentially misleading financial ratios and indicators.
How Under Accrual Happens:
- Inaccurate Estimates: If the company has underestimated the costs or revenues related to a particular item or transaction.
- Oversight or Errors: Sometimes, an under-accrual can occur due to a simple oversight, misunderstanding, or computational error during the accounting process.
- Timing Issues: Accruals often rely on timing, and a delay in processing or recognizing an expense or revenue can lead to under-accrual.
- Overstated Profits: If expenses are under-accrued, it could lead to an overstatement of profits, which can mislead investors and other stakeholders.
- Understated Liabilities or Assets: Under-accruing expenses or revenues can also affect the balance sheet, as liabilities or assets might be understated.
- Tax Implications: Incorrectly reported income can also have tax implications, as it might lead to incorrect tax filings.
An under-accrual needs to be corrected as soon as it is identified. This usually involves making additional adjusting entries to properly account for the missed or understated accruals.
Example of Under Accrual
Let’s dive into an example to illustrate the concept of under accrual, using a fictional company called “TechFix Inc.” which provides tech support services.
TechFix Inc. has a contract with a client for annual maintenance services, costing $12,000 per year. This works out to $1,000 per month. However, due to an oversight, TechFix’s accounting department only accrues $800 per month for this contract.
Initial Accrual Entry:
At the end of the first month, TechFix records the following journal entry to recognize the revenue that should be accrued:
- Debit Accounts Receivable: $800
- Credit Service Revenue: $800
At this point, TechFix has under-accrued its revenue by $200 ($1,000 actual – $800 accrued).
Identifying the Under Accrual:
After reviewing the contract during an internal audit, the accounting department realizes that they have been under-accruing revenue by $200 per month. They decide to correct this mistake.
Adjusting Entry for Under Accrual:
To correct the under accrual, TechFix would need to make the following adjusting journal entry:
- Debit Accounts Receivable: $200
- Credit Service Revenue: $200
This entry corrects the under-accrued revenue, and the Accounts Receivable and Service Revenue accounts now reflect the correct amounts for the month.
- Financial Statements: Before the correction, the company’s revenue and accounts receivable would have been understated, misleading stakeholders about the company’s financial performance.
- Cash Flow: The under accrual doesn’t directly impact cash flow, as it’s an accounting adjustment, but it does give an inaccurate picture of expected future cash flows from receivables.
- Compliance and Reporting: Incorrect accruals can create issues with tax authorities or regulatory agencies, as well as mislead investors, so it’s critical to correct them as soon as possible.
By identifying and correcting the under accrual, TechFix ensures that its financial statements more accurately reflect its true financial condition and operating performance.