Accrual Rate – Definition

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Accrual Rate Definition

Accrual rate refers to the interest percentage rate charged on financial instruments such as bonds, pension, credit card, and mortgage loans among other loans. Accrual rates vary according to the financial instrument.

However, it is commonly applied on bonds to find out the amount of interest expense accrued for various interest payments. The reason why the rate is commonly used on bonds is that the interest from bonds is paid at intervals (semi-annually). Meaning the interest expense accrued rate has to be determined throughout the interval periods.

A Little More on What is an Accrual Rate

Generally, the accrual rate helps you to know the financial obligation’s rate on interest accumulation. This includes its price and value which are important financial elements. Accrual rate can be said to be an abbreviation for the accrued expense and accrued revenue.

This is because they have a mutual name word. However, their opposite economic and accounting feature is what makes them different.

 

  • Accrued Revenue

 

This refers to the earnings that have not yet been paid. The earnings are generated from either good delivered or from services offered. Meaning, there is income earned from a recognized revenue item whose payment is done at a later date.

The payment is usually done after deducting the amount from the accrued revenues. In this type of accrued rate, there is acknowledgment before the cash is received. A good example could be in the rental industry where there are rental revenue accruals which in most cases goes beyond the end month dates.

For instance, we have cases where a contract may specify a starting date to be 15 January. In this case, the invoicing of the rent dues will not be done until February 14th. Meaning, by the end of January, there will be sixteen day’s accrued earnings worth of the charges per month.

 

  • Accrued Expense

 

An accrued expense may refer to a liability whose amount and time of payment is not known. The uncertainty regarding the accrued expense happens because of the invoice’s pending delivery. In this case, the existence of the expenses is recognized even before the money is cashed out.

Therefore, we can say that the accrued expense is a pending debt that awaits payment either for goods or services received. This is usually initiated after the amount is subtracted from the accrued expenses.

An example of this is when there is a pending payment for the already delivered goods or services because the invoice has not been received. Note that it is from the invoice that you are supposed to tell the amount you owe service provider.

Therefore, you cannot be able to initiate the payment because you are uncertain about the total amount to be paid. This means payment will have to be done at a later date when the invoice is finally received.

Calculating an Accrual Rate

The accrual rate calculation can be done on a daily, monthly or semi-annually basis. Below are calculation details depending on their intervals.

  • Daily Accrual Rate Calculation

To calculate the daily accrual rate on any financial instrument, you will pick the interest rate and divide it using the number of days in a year. You then multiply the outcome by the remaining amount (outstanding principal balance).

  • Monthly Accrual Rate Calculation

Similarly to the daily accrual rate, the monthly accrual rate is also calculated by dividing the yearly interest rates by twelve months. You then take the results and multiply it by the outstanding amount (balance).

Generally, the accrual rates are supposed to reflect positive values. However, they can as well be negative, especially when the season is experiencing losses on interest rates.

Where to use Accrual Rates

The accrual rates can be used in the following areas:

 

  • Accrual Accounting

 

Accrual rates can be used where accrual accounting is applied. In this accounting method, there is a recording of income and expenditure during the transaction time. This is done without the cash being received or not yet cashed out.

  • Non-Financial Context

In this context, the accrual rate tracks and calculates payments in the non-financial setting. The non-financial context may include vacation time, pension scheme, sick offs among other paid time off.

  • Pension Accrual Rate

The accrued rate in pension refers to the pension interest rate that individuals earn for being members of a pension scheme. Accrual rate is, therefore, in part used to calculate employees’ final salary scheme alongside other metrics. When calculating pension benefits, accrual rate plays an important role. This rate is the one used to determine pension benefits while one is still an active contributor to a pension scheme.

Generally, when it comes to calculating accrual rates related to pension, there are 4 important elements which determine how the pension scheme will provide benefits to its members. The elements are as follows:

  • Pension service duration from the time you were credited as being an active participant of the pension scheme.
  • Your pensionable Income (salary)
  • The accrual rate or formula used on income and services to calculate your pension.
  • The prevailing circumstances that caused the benefits to be taken from the pension scheme. Situations such as ill-health, early leaver, early payment, and death is a good example of conditions that can lead to your benefits being taken from the pension scheme.

 

  • Vacation Accrual Rate

 

Also, the accrual rate can be used to calculate employee’s vacation earnings. It is upon the employer, in this case, to decide on the accrual rate that applies to vacation or paid time off (PTO). For instance, an employer may set an employee’s vacation rate to be 4 hours per 120 hours. Accrual rate vacation time, in this case, is determined by the employer’s provided earning rates.

In addition, there are several options in which vacation time can accrue. The suitability of each method varies depending on different levels of needs and situations. However, it is important to note that the method of awarding vacation time mostly lies with the employer.

Some employers may decide to award this in lump sum usually at the start of the year. In short, the accrual rate all depends on the organization’s laid down procedures. The options are as follows:

  • Once per year worked

This refers to a lump sum vacation time award. Here, an employee is given all of his or her accumulated vacation or time off once a year. This is mostly awarded at the start of the year. This method fits well when used on permanent or full-time employees.

Most employers prefer using this method when awarding vacation time to their employees. This is because it is less tiresome as the employer deals with the calculation only once a year. On the other hand, the method is advantageous to the employees as they get enough time away from work. This gives them a good time to relax and give themselves a new lease on life.

However, the method has one major disadvantage to the employer. It may be difficult for an employer to keep track of the employees’ accruals throughout the year. This is more especially where the employer has to deal with a big number of employees. In this case, the employer will need to set up an automated system that can help in tracking the time off accruals for each employee.

Also, this method of awarding vacation or time off has a few drawbacks to the employees. For instance, an employee may decide to end the contract at a time when the organization owes him or her a full year vacation payout. Remember that, not all states tasks employers to pay their employees their vacation accrued benefits at the time of the contract termination. In this case, employees from such states will definitely lose all of their accrued vacation pay.

  • Per hour worked

In this method, time off calculation is done based on the number of hours an employee has worked within the payment period. This method works well where part-time employees are involved. The method ensures that employees earn a fair time off benefits.

  • Per period worked 

Per pay period, means that the vacation time calculation is done in line with the pay period. The pay period here may refer to, weekly, monthly or bi-weekly.

Accruals in Payroll

This an obvious benefit that an organization awards to its employees. The accruals in payroll include a vacation or sick off. In this case, employees accumulated vacation time or sick leave which is put in a bank.

The payroll provider then keeps track of employees’ used sick leave or vacation. Note that under this rate, there are situations that will determine how the accrual rate in payroll is calculated. The calculation will be based on the following factors:

  • Length of service-Here, the employee’s rate of vacation time or sick leave accumulation is determined by how long the employee has worked in the organization.
  • Trial Period-During trial period for especially for new employees, there is usually no vacation time or time off until the probation is over. This means that the awarding of vacation time or sick off accruals is done after the trial period has elapsed. However, if need be, an employee can still apply for sick off leave and still get paid for it while still on trial period.
  • Carry over-This is also referred to as a rollover. In some cases, employers have policies that allow their employees to carry over their accrued vacation time or sick off leave in the following year. However, if such policies are not provided, then the employee loses any accrued time when the employer’s calendar year crosses over to a new.

Bottom Line

Accrual rate varies from one organization to the other. What one organization offers may not be the same as what the other has. The accrual rate that each firm offers is majorly depended on their employment terms and conditions.

Therefore, it is that you keenly go through employment terms and conditions when taking on a job. This will help you to know what their accrual rates for different employee’s benefits are.

Reference for “Accrual rate”

https://www.accountingtools.com/articles/2017/5/7/accrual-rate

https://www.investopedia.com › Investing › Financial Analysis

https://financial-dictionary.thefreedictionary.com/Accrual+Rate

www.businessdictionary.com/definition/accrual-rate.html

www.mycompanypension.co.uk/What-is-an-Accrual-Rate-Pensioner-Members-DB

https://www.myaccountingcourse.com › Accounting Dictionary

Academic research on “Accrual rate”

Accrual accounting, modified cash basis of accounting and the loan decision: An experiment in functional fixation, Riahi-Belkaoui, A. (1992). Accrual accounting, modified cash basis of accounting and the loan decision: An experiment in functional fixation. Managerial Finance, 18(5), 3-13. The paper presents the results of an empirical study in which bank loan officers evaluated a loan application which were accompanied by financial statements based on either accrual accounting or modified cash basis of accounting (MCBOA). The loan officers first decided whether to grant the loan and determined an interest rale. Second, they evaluated the financial statements information on the basis of three quality attributes: Overall reliability, freedom from clerical errors and freedom from the effects of fraud. The results verified a functional fixation hypothesis by showing that the loan officers examining the financial statements of the same company using either accrual information or MCBOA showed clear preference for the company when faced with accrual information. A conditioning factor is used to explain the results.

Accrual accounting, modified cash basis of accounting and the loan decision: An experiment in functional fixation, Riahi-Belkaoui, A. (1992). Accrual accounting, modified cash basis of accounting and the loan decision: An experiment in functional fixation. Managerial Finance, 18(5), 3-13. The paper presents the results of an empirical study in which bank loan officers evaluated a loan application which were accompanied by financial statements based on either accrual accounting or modified cash basis of accounting (MCBOA). The loan officers first decided whether to grant the loan and determined an interest rale. Second, they evaluated the financial statements information on the basis of three quality attributes: Overall reliability, freedom from clerical errors and freedom from the effects of fraud. The results verified a functional fixation hypothesis by showing that the loan officers examining the financial statements of the same company using either accrual information or MCBOA showed clear preference for the company when faced with accrual information. A conditioning factor is used to explain the results.

Regulatory capital, tax, and earnings management effects on loan loss accruals in the Canadian banking industry, Chen, P., & Daley, L. (1996). Regulatory capital, tax, and earnings management effects on loan loss accruals in the Canadian banking industry. Contemporary Accounting Research, 13(1), 91-128. This paper examines the degree to which managerial discretion over accruals relating to loan losses in the Canadian banking industry during 1977–87 may have been utilized to manage regulatory capital, taxable income, and reported earnings. These years reflect a unique period in which accounting and regulatory practices differed significantly from the post‐1987 period. These prior practices created different types of incentives and highlighted different policy issues such as the role of tax benefits in loan loss accrual decisions. We model a three‐equation, simultaneous system around three annual discretionary choices: the amount of loan loss experience accrued (based on specific provisions), the size of reserve transfers to the Appropriation for Contingencies (based on general provisions), and the extent of external regulatory capital raised. Results indicate strong support for the capital maintenance predictions and weaker, but significant, support for the tax management predictions. Results do not support the predictions of the earnings management hypothesis.

Accounting accruals and auditor reporting conservatism, Francis, J. R., & Krishnan, J. (1999). Accounting accruals and auditor reporting conservatism. Contemporary accounting research, 16(1), 135-165. Accounting accruals are managers’ subjective estimates of future outcomes and cannot, by definition, be objectively verified by auditors prior to occurrence. This causes audits of high‐accrual firms to pose more uncertainty than audits of low‐accrual firms because of potential estimation error and a greater chance that high‐accrual firms have undetected asset realization and/or going concern problems that are related to the high level of accruals. One way that auditors can compensate for this risk exposure is to lower their threshold for issuing modified audit reports, an action that will increase modified reports and, therefore, lessen the likelihood of failing to issue a modified report when appropriate. We call this auditor reporting conservatism and test if high‐accrual firms in the United States, are more likely to receive modified audit reports for asset realization uncertainties and going concern problems. Empirical results for a large sample of U.S. publicly listed companies support the hypothesis that auditors are more conservative, that is, more likely to issue both types of modified audit reports for high‐accrual firms. Further analyses show that income‐increasing accruals are somewhat more likely to result in reporting conservatism than income‐decreasing accruals, and that only the Big Six group of auditors show evidence of reporting conservatism. These findings add to our understanding of the audit report formation process and the potentially important role played by accounting accruals in that process.

Nonlinear dynamics in discretionary accruals: An analysis of bank loan-loss provisions, Balboa, M., López-Espinosa, G., & Rubia, A. (2013). Nonlinear dynamics in discretionary accruals: An analysis of bank loan-loss provisions. Journal of Banking & Finance, 37(12), 5186-5207. Several studies have analyzed discretionary accruals to address earnings-smoothing behaviors in the banking industry. We argue that the characteristic link between accruals and earnings may be nonlinear, since both the incentives to manipulate income and the practical way to do so depend partially on the relative size of earnings. Given a sample of 15,268 US banks over the period 1996–2011, the main results in this paper suggest that, depending on the size of earnings, bank managers tend to engage in earnings-decreasing strategies when earnings are negative (“big-bath”), use earnings-increasing strategies when earnings are positive, and use provisions as a smoothing device when earnings are positive and substantial (“cookie-jar” accounting). This evidence, which cannot be explained by the earnings-smoothing hypothesis, is consistent with the compensation theory. Neglecting nonlinear patterns in the econometric modeling of these accruals may lead to misleading conclusions regarding the characteristic strategies used in earnings management.

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