Accrual accounting is a system used by companies to record their financial transactions at the point when they occur regardless of whether a cash transfer is made. It is unlike cash accounting under which a transaction is deemed as valid for recording when cash is actually received or paid.
Accrual concept of accounting requires that accounting records including journals, ledgers and income statement reflect transactions at the time when they actually occur, not necessarily when cash changes the hands. This basis of accounting is generally used in preparing financial statements, except for cash flow statement.
Under accrual accounting a revenue is recorded when it is earned, regardless of when it is received in cash and expenses are recorded when benefit from it is gained, regardless of when it is paid in cash. Also read revenue recognition principle and expense recognition principle.
Let’s take an example for a better understanding of the concept
Example of accrual concept:
Suppose Mr. John obtains a building from Mr. Sam for business purpose at a rent of $100,000 per year. Now consider the following three cases in which John pays cash to Sam and records the rent expense in his business books.
In above example, even though the amount of cash paid is different in all the three cases, the rent expense recorded is $100,000 in each case. Justification behind this is the accrual concept of accounting in which expenses must be recorded in the accounting period in which they are incurred, not in the period in which they are paid.
Notice that in case “B” John has paid $80,000 cash but has recorded $100,000 expense during the period because the annual rent of building is $100,000, not $80,000. The remaining $20,000 is a current liability, known as rent payable, which will be settled in subsequent period. Also notice that in case “C” John has paid $150,000 cash but has again recorded only $100,000 as rent expense. The balance of $50,000 is a current asset, known as prepaid rent, which can be adjusted against the rent of subsequent period.
The accrual concept of accounting may be complex for some people but has many benefits. It is also one of the basic requirements for keeping records under major accounting frameworks like US-GAAP and IFRS.
Benefits and importance of the accrual approach:
The importance and salient benefits of following an accrual concept of accounting are listed below:
- Under accrual concept of accounting, financial statements reflect all the expenses associated with the reported revenues for an accounting period. The usability of financial information is thus increased.
- It satisfies the requirements of major accounting standards applicable in the world such as generally accepted accounting principles (GAAP) and international financial reporting standards (IFRS).
- It is considered one of the general assumptions while interpreting financial statements by various users.
- The departure from accrual concept ceases the ability of users to compare the financial statements of an entity with that of others which ultimately results in less lucrative from investors’ perspective.
- The concept makes financial information more accurate and more reliable for general users.