Accruals

What are accruals

Accruals refer to the money that a business has either earned or spent, but not recorded in the financial statements during a specified period. These often include unpaid salaries, interest earned but not received, or taxes. Accruals help match the income and spends with the period when they occurred, providing businesses with a clear picture of their financial performance.

Why accruals matter

Accruals show the real cost of paying employees, even when payments occur at a later stage. Without accounting for accruals, business costs may appear lower than they really are.  Therefore, accruals help represent the true expenses of a business, allowing business owners to make informed financial and budgeting decisions.

For the payroll teams, accruals help track wages that have been earned but are still pending payment. HR teams use accruals data to plan employee benefits, bonuses, and vacation days. They also use this data to record employee entitlements and maintain legal compliance. Accruals help businesses make their financial reports more accurate, transparent, and trustworthy for banks or investors, especially when seeking loans or investments, respectively.

Use cases

Accruals hold significant importance for small to mid-sized businesses, with say 10 to 500 employees. Accounting for accruals help keep track of costs including salaries, bonuses, and unused vacation time; and match these expenses with their correct time periods. Because small businesses generally lack a steady cash flow, knowing what they owe their employees can help them plan ahead and avoid monetary shortfall or legal troubles.

For instance, a construction company with about 50 employees has workers earning their wages every week. But the company pays them every fortnight. Here, the company must record the wages earned every week as accruals, even though it pays the workers later. This helps the company understand the actual cost of labor for the project as it happens, thereby getting a clear picture of the cash flow and preventing potential problems.

In another example, a dental franchise with around 20 employees, offers performance-linked bonuses to its employees, payable in the month of January. In November, although the employees have earned a portion of the bonus, they will be paid only in January. By recording the portion of the bonus earned till November as accruals, the franchise can set aside enough cash for bonus payout in January and save itself from the shock of a large lump sum cash outflow.

Consider a mid-sized accounting firm with 120 employees that works on clients’ tax returns from January through April. The firm does not bill its clients till the completion of the work, but records the financial value of the work done every month as accrued unbilled revenue. Although no cash is received, the firm is still able to use accruals data to gauge the real income it earns each month and plan its finances, budget, and check payroll accordingly.

Similarly, a fast-food franchise operates across 25 locations and employs hundreds of part-time workers, who earn paid time off (PTO) hours throughout the year. Regardless of whether a worker has used the PTO or not, the franchise must record the value of the earned, but unused, PTO as an accrual each month. This way, the franchise can keep track of the monthly outflow of cash if the workers do choose to use their PTO or separate from the company.

Legal considerations

In the U.S., the Fair Labor Standards Act (FLSA) mandates businesses to declare their true income and expenses. Businesses can use accruals to present accurate financial reports to the banks, investors, and government agencies, as well as comply with legal requirements and build trust among employees.

If a business fails to record the unpaid wages, vacation time, or other such expenses, it risks non-compliance and punitive action. A business is also at risk of audits and fines if the IRS discovers that the business did not report genuine income and expenses for taxes.

Additionally, there are certain States that require businesses to track expenses related to earned vacation time, even if the employee did not use it. For example, if a small café in California offers PTO to its 30 employees and few workers do not use it by the end of the year, the café, in compliance with the State law of California. must still pay out any unused PTO at the end of the year or on employee separation. Furthermore, to remain compliant, the café must record the value of the unused PTO as an accrual in its financial reports, regardless of not having paid the employees yet.

Failing to track accruals can lead to non-compliance, fines, and even the business being flagged by the IRS for misrepresenting expenses when it files year-end taxes.

Factors affecting accruals

There are several factors that can affect how accruals are calculated and recorded. For instance, the type of employee, whether full-time, part-time, exempt, or non-exempt. Knowing the correct category of the employee defines how the wages and time off are earned.

Similarly, accruals can be influenced by company policies, such as the frequency at which PTO is available to employees, the prerequisites to earn bonuses, and the payroll schedule (weekly, bi-weekly, monthly).

Another important factor affecting accruals is time tracking, as incorrect worker hours can lead to wrong accrual amounts.

New hirings, attrition, or change in worker profiles, as well as State-specific labor laws compliance also have a huge impact on how and when businesses must record certain benefits, affecting wages and benefit accruals.

Misunderstandings around accruals

Some of the common misunderstandings around accruals include:

• Considering accruals as the money that has already been spent. Whereas, accruals only indicate that an expense or income has occurred, but actual cash is yet to move.
• Believing accruals apply only for large companies. Even small and mid-sized businesses need accruals to accurately track real expenses and income.
• Thinking if something hasn’t been paid yet, it does not need to be recorded. Records are essential from both financial and legal perspectives.
• Considering accruals as unnecessary accounting work. Accruals help businesses improve financial planning to avoid surprises and stay compliant.
• Treating all time off as the same. Different types of leaves have different accrual rules. Treating them all in the same manner can cause payroll or legal problems.

Common pitfalls and ways to avoid them

Many businesses encounter problems with accruals. However, an understanding of the common pitfalls and how to avoid them can help them improve financial reporting, stay compliant, and strengthen employee relations. These include:

• Misclassification: Incorrect job classification of employees as exempt or non-exempt can result in flawed overtime accruals. Businesses must regularly review employee classification for accuracy and compliance with the State’s labor laws.
• PTO Tracking: Failure to track PTO can lead to employees not getting the time off or the wages they’ve earned. To avoid such a mishap, businesses must implement automated tools that track PTO balances during each pay period for proper accruals.
• Time Tracking: At times, employees fail to record their work hours correctly. This can affect payroll and accruals, ultimately leading to underpayment. Using digital time-tracking systems can help remind employees to record their hours regularly.
• Employee Benefits: Neglecting accounting for employee benefits like health insurance or bonuses, as they are earned, can negatively impact the accuracy of financial reports. To ensure correct reporting, businesses must record benefit costs as accruals that can be matched with the period they were earned in.
• Unaccrued Adjustments or Wages: In an instance where an employee has worked but not been paid, failure to accrue for unpaid wages can cause misrepresentation of profit and loss statements. Businesses must keep accruing wages as they are earned and not wait for when they are paid.
• Schedules: Inconsistent or lack of accruals schedules can create gaps in reporting. Creating and following regular accruals schedules can help avoid distorted financial statements and maintain consistency across reporting periods.
• Tax Liabilities: Ignoring accrual for payroll taxes as they are earned can cause tax surprises. To meet tax obligations on time and avoid potential penalties, businesses must ensure accruals for payroll taxes on the same schedule as payroll.

How Fingercheck helps

Fingercheck’s automated payroll services and tracking of accruals like paid time off (PTO), vacation days, sick leave, wages, and benefits, makes accrual management simple and efficient. Businesses can use its user-friendly platform and mobile app to set up custom accrual policies for PTO, sick days, and vacations, ensuring every employee receives the correct amount of time off.

Fingercheck automatically calculates the time off each employee earns and keeps track of accruing wages and taxes. By accurately recording the earned wages that are yet to be paid, and updating accrual balances in real time, Fingercheck helps employees and managers to stay informed about the PTO balances and upcoming liabilities, while also ensuring compliance with the prevailing State regulations. Get in touch with us now.

Fingercheck and any related entities do not offer tax, accounting, or legal advice. This content is designed for informational purposes only and should not be considered a source of tax, legal, or accounting advice. It is recommended that you consult your tax, legal, and accounting advisors before undertaking any related activities or transactions.