The 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 has been made. It is unlike cash accounting in which transaction is deemed as valid for recording when cash is actually received or paid.
Accrual concept of accounting requires that financial statements 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. Revenue is recorded when it is earned regardless of when it is received and expenses are recorded when they are incurred, regardless of when they are paid.
Suppose John rents a house from Sam at $100,000 per year. Now consider the following three cases in which John pays cash to Sam and records rent expense.
In above example, even though cash paid is different in all the three cases but the rent expense recorded is $100,000 in each case. Justification behind that 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 is $100,000 not $80,000. The remaining $20,000 will be paid subsequently. Also notice that in case “c” John has paid $150,000 but has recorded $100,000 expense, the balance of $50,000 will be adjusted against the rent of subsequent period.
The acrual concept of accounting may be complex for some people but has many benefits. It is also one of the basic requirements of major accounting frameworks like US-GAAP and IFRS.
Benefits and importance of the accrual approach:
- 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 the users to compare the financial statements of an entity with that of others which ultimately results in less lucrative from investors’ point of view.
- It makes financial information more accurate and more reliable.