Correct Method of Handling Accruals
To show all earnings in the period in which they actually accrue is called the “accrual method.” Under this method the income earned but not received during the current period is set up among the assets, just as in the case of sales, with this difference, however: the claim for the broken portion belonging to this fiscal period need not be recorded day by day but only at the end of the period. Most income items of this sort are due, either by contract or by custom, at the end of certain definite periods. The setting up of a claim for a broken, i.e., an uncompleted portion, does not mean that such a claim is on that date legally enforceable, but that it is a claim equitably belonging to the current period.
Showing of Accrued Items on Balance Sheet
As to the section of the balance sheet in which these accrued income items should be shown, usually they are true current assets and should be so listed. They frequently arise in connection with current assets, e.g., the interest accruing on notes, stocks, and bonds held, and are therefore just as current as the assets themselves, or even more so. Where not so arising, as in the cases of rents, royalties, etc., usually the contract or customary period of settlement is so short as to make the claims under them true current assets. Occasionally the accrued earning is added to the value of the particular asset and so shown in the balance sheet. A better practice, because more definite, is to list them separately under the title, Accrued Income, Accrued Accounts Receivable, or other similar title.
Valuation of Accrued Items
The principle of valuation of accrued income items is apparent. On the supposition that the concern will continue in business, the accrued income is proportioned between the two periods on the basis of the portion of the time belonging to each period. However, this does not mean that the portion so taken shall be valued at its face. The accrued portion is worth as a portion neither more nor less than the whole is worth as a whole. If there is doubt as to the ability to collect it when it falls due, certainly the valuation placed on the accrued portion should express that doubt. In other words, unless the claim is fully secured by collateral or other pledges, valuation should be on exactly the same basis as for the other receivable items, such as the claims against trade debtors, other open accounts receivable, notes receivable of various kinds, etc.
Accounting for Accrued Income
The accounting for accrued income presents no particular difficulties. In addition to the two methods discussed in Volume I, pages 116 to 119, a third which is considerably more laborious than either of them is frequently employed, and is as follows: At the time of adjusting and before closing the books, for every item of accrued income a separate asset account is set up. Thus, for royalties an account, Accrued Royalties Receivable, would record the claim on account of royalties at the same time the accrued income from royalties is being recorded in a suitable income account. Thus there is distinct separation of the asset and income elements.
From this point two methods are in use for handling the subsequent record of the item. Under the first method, the income when actually received or legally due is recorded in the regular income account. This thus shows an inflated figure because it is not offset by the portion credited to the previous period, the asset account covering this, remaining unchanged throughout the current period. At its close, however, proper adjustment is made by adding to, or subtracting from, the amount held over from the close of the previous period such an amount as will make its new balance show the correct amount of accrued income as at the close of the current period. The contra credit or debit to the above entry, as the case may be, is of course to the particular income account, causing it to reflect the true income for the current period.
Under the second method, the first entries for the new year consist in transferring all accrued income asset balances to their respective income accounts, where they serve the purpose of automatically adjusting the full receipt of income a portion of which was credited in the previous period, to the amount properly belonging to the current period. At the close of the period any adjustment on account of accrued income is handled by debiting the asset account and crediting the income account exactly as before.