Accrual basis of accounting suggest that events are required to recorded in the books of accounts when such events happen and not when the actual cash is paid or received. In other words revenues or incomes are recongized when then are earned and not when they are received. Similarly, expenses and losses are recognized when they are incurred and not when they are actually paid for.
Examples
- 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.
This concept will be explained in detail in later chapters.
Why accrual basis?
Reason to capture events when they happen is that if recording is delayed until actual cash moves in or out then it might be very late. Late in the sense that event end up recording in a wrong accounting period. For example sales were made in the month of January and debtor is given 2 months credit i.e. cash will be received by March. In this case if we wait for cash to be received then sales will be recorded in March which is not correct.
Recording sales in the month of January means that it will be recorded as receivable. That means, recording events on accrual basis not only help us track past events but also inform us about future events connected to such past events (in our example cash to be received by March). This increases the relevance of information.