Accrual Basis of Accounting
The accrual basis of accounting is a concept as per which revenues are recorded in the entity’s books of accounts only when earned (rather than when the entity receives cash from customers) while expenses are recorded when incurred (rather than when cash is paid by the entity).
How Accrual Accounting Works
The general concept behind the accrual basis of accounting is that economic events/ transactions are recognized by matching revenues to expenditures (the matching principle) at the time when a transaction takes place rather than when payment is made to vendors or is received from customers. This method allows the current cash outflows or inflows to be combined with expected cash outflows or inflows in the near future to give a clear picture regarding a business entity’s current financial position.
When revenues are earned but payment is yet to be received from customers then in such situations business entities use asset accounts named accounts/ trade receivables for the recording of revenues earned but yet to be received. Under cash basis accounting, revenues are not recorded in ledgers until payment is received from customers.
Also under accrual accounting, expenditures are reported on the statement of profit or loss when they are matched with revenues reported. When an expenditure is incurred but cash is yet to be paid then in a situation like this business entities use a liability account to record expenses that have been incurred but are yet to be paid for. Under cash accounting expenditures are not recorded in ledgers until the payment is made against them.
Example of Revenues Recorded Under Accrual Accounting
For example, A Company named EFG has started business in the month of December and during its first month of operations, it provided accounting services worth $10,000. The company has a policy of allowing its customers to pay their dues within 30 days, but the company did not receive a single dollar from its customers in December. The revenue of $10,000 earned by the company in the month of December was instead received in the month of January. Under accrual accounting, the company EFG will record and report revenue of $10,000 it earned in the income statement for the month of December and will report receivables of $10,000 on its statement of financial position as of December 31.
Example of Expenses Reported Under Accrual Accounting
For example. Company EFG paid $1,500 against office rent and incurred another $300 against utilities used in the month of December. However, the company will not receive the bill for utilities for the month of December until January 10. Under accrual accounting, the company will record office rent expense in the month of December because office rent was used up in that same month, and it will also report an estimated figure for utility expenditure of $300 so that the income statement for the month of December provides a better and clear picture of the company’s profitability in December. Also, the company will report a liability of $300 against its December utility expenses to communicate a more clear and accurate picture of the company’s obligations as of December 31.
Comparing Accrual Basis to Cash Basis
Using accounting transactions mentioned above, under accrual accounting will result in the company reporting revenue of $10,000 and expenditures of $1,800, and a net profit of $8,200.
Under cash accounting, the income statement for the month of December will report revenue of $0 and expenditures of $1,500, and as a result a net loss of $8,500.
The companies that comply with International Financial Reporting Standards are required to prepare their financial statements by using the accrual basis of accounting.