Accrual concept is the most fundamental principle of accounting which requires recording revenues when they are earned and not when they are received in cash, and recording expenses when they are incurred and not when they are paid.
GAAP allows preparation of financial statements on accrual basis only (and not on cash basis). This is because under accrual concept revenues and expenses are recorded in the period to which they relate and not when they are received or paid. Application of accrual concept results in accurate reporting of net income, assets, liabilities and retained earnings which improves analysis of the company’s financial performance and financial position over different periods.
At the end of each reporting period, companies pass adjusting journal entries to record any accruals, for example accrual of utilities expense, interest expense, accrual of wages and salaries, adjustment of prepayments, etc.
The following examples elaborate the accrual concept.
- An airline sells its tickets days or even weeks before the flight is made, but it does not record the receipts as revenue because the flight, the event on which the revenue is based has not occurred yet.
The airline journalizes receipt of cash as follows:
Bank ABC Unearned revenue ABC Unearned revenue ABC Revenue ABC
- An accounting firm obtained its office on rent and paid $120,000 on January 1 as annual rent. It does not record the payment as an expense because the building is not yet used. Instead it records the cash payment as prepaid rent (which is a current asset):
Prepaid rent DEF Bank DEF Rent expense GHI Prepaid rent GHI
- A business records its utility bills as soon as it receives them and not when they are paid, because the service has already been used. The company ignores the date when the payment will be made.
An alternative to accrual basis is the cash basis of accounting. Under the cash basis, transactions are recorded based on their underlying cash inflows or outflows. Cash basis is normally used while preparing financial statements for tax purposes, etc.
Written by Obaidullah Jan, ACA, CFA