According to accrual concept or accrual principle or accrual basis of accounting revenues and expenses are recorded in books of accounts when they are earned or incurred and not when they are received or paid in cash.
In essence events of business are captured in accounting system when they are actually happening and not when cash flows in or out as in many cases timings of cash flows are different from the time when transaction actually occurred. If we wait for cash, then recording might be so delayed that it is either recorded in a different period or the time until we record the transaction it will have no relevance in that period for economic decisions.
Many accounting frameworks around the world suggest using accrual basis of accounting and this concept is one of the fundamental assumptions in preparing financial statements in two of the widely used accounting frameworks i.e. US GAAPs and IFRSs. The reason is accrual basis of accounting provide more accurate view of entity’s financial position and financial performance. Because recording under this principle is not delayed. So we can safely say that accrual basis provides more accurate information regarding revenues earned and expenses incurred during the period and in addition to that what effects transactions of this period have in future. Lets understand all this with an example.
For example a credit sale was made to one customer worth 5,000 in the month of July. Customer has promised to make the payment by next month i.e. August.
If recording of 5,000 is delayed until the month of August i.e. cash is actually received then financial statements prepared for month ended July will not give an appropriate view of the business due to following reasons:
- Sales revenue will be understated by 5,000 because entity has earned the income. Its just that cash has not reached entity against such sale. In short incomes are understated.
- Assets of the entity will be understated as entity has the right to receive cash of 5,000 i.e. it is receivable from customer and he is a debtor. Receivables or debtors are assets of the organisation as they owe money to it. So by not recording 5,000 as receivables users will not have any idea how many cash is to be received by the entity in the future.
If the recording is delayed until August, this information by that time will have no use as it relates to July and by August user requires information pertaining to the month of August.
Another example is of expenses like electricity bills, rentals, salary expenses etc. We record electricity expense as and when electricity is received and not when they are actually paid. Similarly rental are reported as expense when they fall due and not when actually cash is paid in this regard. Same is the case with salaries, wages, interest and other expenses.
Understanding these drawbacks of cash basis accounting, accounting frameworks require financial statements to be prepared on accrual basis as it is critical to users’ understanding and in having relevant information.
One point to remember however is that financial statements prepared under GAAPs or IFRSs are general purpose financial statements that caters general needs of users. Any specific accounting framework requiring special purpose financial statements accommodating special needs of users may require different basis for example certain industries in different countries are required to prepare accounts on cash basis.
Moreover, under given circumstances accounting framework may require to prepare financial statements on different basis. For example if entity is no more a going concern then financial statements are prepared on break-up basis which may or may not allow for accruals.
- In case of credit sales customers are allowed to pay after some time e.g. in 30 days or 60 days. In such cases revenue from sales is recorded when sales actually happen and now when cash is received 30 or 60 days later.
- Most of the time employees are paid on fifth day of next month for the previous month worked e.g. compensation of 1,000 for the month of January is paid on February 5. However, if financial statements for the month of January are prepared 1,000 will be recorded as payable expense as it is incurred in January instead of recording it in February when it is paid.
- When building or a piece of land is acquired on rental basis then tenant is often required to pay the rent in advance (prepaid rent) at the beginning of period. This is a special case of accruals concept. Although the payment (lets say 12,000) has been made but it will not be recognized as expense as it is yet to be incurred. Therefore, whole amount paid will be recorded as an asset yet to be consumed. Later in the year after quarter has completed (January, February and March) rentals of 3 months (3,000) will be recorded as an expense and then balance (9,000) is still kept as asset in the financial statements.
- Almost all educational institutes ask for tuition fee to be paid in advance to them. This is the income received in advance by the institute but it will be recorded as liability as it is yet to be earned and will be recorded as income considering the course completed. For example if 60% course is completed then 60% of amount received in advance will treated as income and rest is still presented as liability in the financial statements.
- Utility bills like electricity bill for the month of January might have a due date falling in February but it is recorded at the date of receipt if it is received within the month of January. Due date is the date when bill is to be paid and not the date when expense was incurred.