Accrual Principle
A fundamental accounting principle that instructs accountants to record the transactions in the periods they have occurred.
What is the Accrual Principle?
The Accrual Principle is defined as a fundamental accounting principle that instructs accountants to record the transactions in the periods they have occurred. The recording of the transaction should be recorded whether the cash is collected or not.
In other words, the accrual principle states that accounting transactions should be recorded in the accounting period in which they occur rather than the accounting period in which the related cash flows occur.
This principle is a fundamental requirement of all accounting frameworks, such as International Financial Reporting (IFRS) and Generally Accepted Accounting Principles (GAAP).
The accrual principle allows us to aggregate all revenue and expense information for an accounting period without the delays and distortions caused by the cash flows arising from that period.
Key Takeaways
- The accrual principle is a fundamental accounting concept that dictates revenues and expenses should be recognized in the periods they are earned or incurred, regardless of when the cash transactions occur.
- Under the accrual principle, revenue is recorded when it is earned, not when the cash is received. This means that sales are recognized when the goods or services have been delivered to the customer.
- Under the accrual principle, expenses are recorded when they are incurred to generate revenue, not when they are paid. This ensures that expenses are matched with the revenues they help to generate.
- While more complex than cash-based accounting, the accrual principle is essential for accurate financial reporting, compliance with accounting standards, and effective financial management.
How Accrual Accounting Works
The concept of accrual accounting is that transactions are recognized by matching revenues to expenses (the matching principle) when the transaction occurs instead of when that payment is made or received.
This method gives a more accurate picture of a company's recent financial position by showing the current cash inflows or outflows combined with future expected cash inflows or outflows.
The accrual accounting principle recognizes revenues, expenses, gains, and losses, as well as the corresponding increase or decrease in assets and liabilities, during the transaction period.
This principle relies on revenue recognition and matching principles, which consider the timing of the recognition of business transactions and events.
Recognition formally records a business transaction or event in an entity's financial accounting records. Realization converts non-cash resources and rights into money by converting claims to cash or selling an asset for cash.
Recognition is the process of recording a business transaction. It establishes the completion of the earning process and is synonymous with cash inflow or cash outflow.
The cash accounting basis considers the realization of — and the resulting cash flow from — a transition or event.
Accrual Accounting vs. Cash Accounting
The key difference between accrual and cash accounting methods is the accounting period in which revenues and expenses are recorded.
Accrual Accounting Method
The accrual accounting method matches revenues against expenses in the accounting period during which the transaction takes place instead of when the payment is received/processed.
The accrual method also requires businesses to factor in "allowance for doubtful accounts" since goods are delivered to customers before payments are received (payment on delivery), and some customers, due to some reasons (like goods no longer needed), may fail to pay for it.
Some customers may pay for the goods in advance (pre-booking the goods) even before the goods are delivered to the customer.
In such an instance, initially, the payment is recorded as a liability for the seller (because the business is then liable to deliver the goods, having received the payment).
When the goods are delivered to its customer, the payment received for the goods is transferred to the revenue account from the liability account.
Similarly, when a bill (expense) is received, it is recorded in the expense account even before payment is made.
Cash Accounting Method
The cash accounting method records the revenue and expense transactions when the payments are paid out or physically received.
This method is confined to small businesses that do not deal with significantly high volumes of transactions.
The advantage of the cash accounting method over the accrual accounting method is that these businesses can account for all cash in hand.
However, if these small businesses trade goods on credit, then they would be unable to account for future payments since cash accounting does not have a means of recording future payments.
Therefore, any business using the cash accounting method may not always present the most accurate view of its actual financial position.
GAAP and IFRS on the Accrual Principle
The accrual concept is generally considered standard accounting practice for large companies. It is considered by the International Financial Reporting Standards (IFRS) and the Generally Accepted Accounting Principles (GAAP).
Generally Accepted Accounting Principles (GAAP) prefer the accrual accounting method because it records sales when they occur, providing a clearer insight into a company's performance and actual sales trends than just when payment is received.
Companies can use accrual accounting or cash methods while preparing their financial statements. However, if a company is public in the US, it must use the accrual accounting method specified by US GAAP.
The US GAAP includes specific revenue recognition standards that businesses must follow to ensure that revenue is recognized when a sale has been made, regardless of when the customer pays for it.
Revenue is recognized if goods are transferred to the customer or services are provided. If the customer has not paid, a corresponding accounts receivable is booked, which is eliminated once the company receives cash.
Apart from just using cash receipts, these accounting frameworks guide businesses worldwide in accounting for revenues and expenses. However, companies still have great flexibility to enact accounts receivable procedures with varying time frames.
GAAP is required for public company accounts filed with the Securities and Exchange Commission (SEC). Non-listed companies may follow GAAP if they need financing or if a third party scrutinizes their accounts; for example, they must be audited.
In any case, accrual accounting is commonplace. Smaller enterprises may use cash accounting, as their accounts are not used externally or by third parties.
Big businesses consider the accrual accounting principle the most valid accounting system for determining their business operations' financial position and cash flows. Revenues and related expenses are recorded within the same reporting period.
Businesses earning over $5 million in revenues must use the accrual principle for tax purposes.
Accrual Basis Accounting
Accrual accounting is a mandate for any regulatory filing that requires US GAAP (For example, in the US), such as a company's annual reports 10-K filing to the Securities Exchange Commission (SEC).
Most investors and financial institutions require GAAP financial statements when evaluating a business, which is a significant reason why accrual accounting is a popular method.
However, a few exceptions do exist, mainly around income taxes. The Internal Revenue Service (IRS) allows small businesses with less than $25 million in annual revenue to choose between accrual or cash-based accounting. Sole proprietors, partnerships, and S-Corps are entitled to use cash accounting.
Examples of the usage of the accrual principle are:
- Recording the revenue while billing the customer rather than when the customer pays.
- Recording an expense when incurred rather than when paid for it.
- Recording the estimated amount of bad debt while billing a customer rather than when it becomes apparent that the customer will not pay back.
- Recording depreciation for a fixed asset over its useful life rather than charging it as an expense in the period purchased.
- Recording a commission when the salesperson earns it, rather than the period they have paid it.
- Recording wages in the period earned rather than in the period paid.
The Need for the Accrual Principle
Some uses for the accrual principle are discussed below.
The Complexity of Business Transactions
The accrual principle was used to respond to the increasing complexity of business transactions. Large companies that trade goods on credit may continue to receive revenue over a long period from goods sold earlier.
Recording these transactions when the payments occur would reflect an inaccurate picture of the company's financial position, as the financial markets require timely and accurate reporting of a company's finances.
With accrual accounting, large businesses can present the most accurate picture of the company's financial position.
Business Performance Measurement For A Particular Period
When any business wants to examine its actual performance during a specific period, such as a quarter or fiscal year, the accrual method of accounting is a valuable tool.
It is based on the matching principle, i.e., revenues are recorded in the accounting period when goods and services are delivered, and expenses are recorded in the accounting period when goods and services are purchased.
Accrual accounting can provide a more accurate overview of a business's performance over a specific period because future revenues and expenses can be accounted for.
The financial information recorded under the accrual accounting principle enables the business to calculate financial metrics such as net income, operating margin, and gross profit margin.
Benefits of the Accrual Principle
Some of the benefits of this principle are numbered below:
- Holistic Approach: Accrual accounting is a comprehensive system, unlike the cash accounting method. A business is not about cash only, as many aspects should be considered. Under the accrual accounting method, all the business's financial transactions (cash and others) can be recorded.
- Financial statements, such as the balance sheet and income statement, are created to give an even better picture of a company's financial health.
- No Discrepancies/Errors: As the financial transactions are immediately recorded as they occur, there is virtually no place for errors, inaccuracies, or discrepancies. Moreover, since everything is always recorded, the information is readily available if one wants to do an audit.
- Better Accuracy: Accrual accounting follows a double-entry system, i.e., one account is debited, and another is credited. It increases the accuracy level of accounting, and later on, during an audit, things get easier.
Limitations of the Accrual Principle
This principle also presents a few limitations:
1. Quite complex
Cash accounting is easy to record and maintain; However, this is not the case with the accrual principle.
Accrual accounting is complicated every time a financial transaction occurs. There should be a record/entry in the books of accounts. Moreover, maintaining the whole accounting system is not an easy task.
2. Holistic but challenging to maintain
A business has different aspects. Moreover, if a business is enormous, hundreds and thousands of financial transactions need to be recorded in a single day under this accounting. Maintaining all of this daily, day after day, is not an easy job for an accountant.
3. Example
The significant limitation of the accrual principle can be easily understood by looking at the example provided below:
Suppose that BNM Company never makes a payment for the raw materials. Such a situation would present a substantial financial problem for company JKF, not just that it would also show the company an accounting problem.
The Accrual accounting principle may indicate that a business generated profits during a specific accounting period while the recorded cash flows are yet to be received.
Potentially, it can portray the business as profitable even when it lacks sufficient cash flow to finance its operations. In extreme cash flow shortages, the company may even become bankrupt despite showing current profits per its financial statements.
Accrual Principle FAQs
The term "accrual" is derived from the fact that all expenses are recognized in an accounting period other than when they are paid and accrued.
An individual Follow The Accrual accounting method as Accounting standards require that revenues and expenses should be recognized when they have been incurred or earned.
The effects of not Applying The Accrual Principle would be that any individual would fail to record expenses incurred, leading to wrong calculations of earnings, which is very important for tax purposes.
Accurate and consistent reporting
The primary objective of Generally Accepted Accounting Principles (GAAP) is to have accurate and consistent rules for financial reporting, and using the accrual method helps achieve this objective.
Whenever a business sells goods and services, even on credit, the transaction is recorded immediately, regardless of whether or not payment is made.
If Generally Accepted Accounting Principles (GAAP) favored using the cash accounting method, then the sale of goods and services sold on credit would not be recorded when the transaction occurs, therefore creating an imbalance, a discrepancy between the sales and inventory records.
In accrual accounting, any business records the revenue transaction when the revenue is earned.
For example, let us assume that LMN Company has contracted XYZ Company to supply construction materials worth $10,000 at its New Jersey construction site. The payment is to be made within 180 days from the delivery date.
When XYZ delivers the construction materials to LMN, it enters the transaction as revenue in its books. When the payment is received or is to be received does not affect the revenue entry in the books of accounts.
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