The accrual principle is a very important concept in accounting, and it forms the basis of making adjusting entries during the accounting cycle, which we have covered before.
The accrual principle requires that transactions be recorded in the period that they occur in regardless of when the actual cash is exchanged. The accrual principle is the basic requirement for all accounting frameworks such as IFRS or GAAP.
Large organizations recognize that the accrual principle is the more valid accounting system for determining the financial performance of their business. Usually, businesses with over $5 million in sales are required to switch from cash accounting to accrual accounting.
The accrual principle is important for the following reasons:
- Complexity of business transactions. The larger an organization, the more complex its transactions will become, and it would not be feasible to rely on cash accounting.
- Measure of business performance. Accrual accounting will provide a more reliable and accurate picture of a company’s performance. This is because all revenues and related expenses have been recorded in the period in which they occur.
Cash Accounting Method
This system is used by smaller businesses as it is relatively simpler and more straightforward as compared to accrual accounting. The cash accounting method means that revenue and expense transactions are recorded as money is received or paid out. The one advantage of using this method is that the business owner has receipts for all the physical cash he has at the end of the period.
However, cash accounting does not usually represent the true financial position of a company. There will be many cases in which the company might sell goods to its customers on credit terms, which will not be recorded as sales until the payments are received. Even though these sales relate to the current period, it will not get recorded until a further date. Therefore, revenues and profits might be misrepresented with the cash accounting method.
Accrual Accounting Method
The accrual method of accounting also works in sync with the matching principle, in which the expenses are recorded with their related revenues in the period in which they occur, regardless of when the cash exchanges hands.
When a sale is made, it is first transferred into an asset account called accounts receivable. This is done by debiting the accounts receivable account and crediting the sale revenue account. Therefore, via this journal entry, the sale is successfully recorded in the period in which it occurs. On a later date when the cash is received, the journal entry needed to record the transaction would be to debit cash account and credit the accounts receivable account.
Similarly, when an expense bill or invoice is received, the journal entry required (as per the accrual principle) would be to debit the expense account and credit the expense payable/accounts payable account. On a later date when the cash is paid out by the company, the journal entry needed to record the transaction would be to debit expense payable/accounts payable and credit cash account.
Examples of the Accrual Principle
Like we saw earlier, the accrual principle is used while creating journal entries to record business transactions. However, it is can also be used to record adjusting entries for a company at the end of the accounting cycle. The three types of adjusting entries are given below:
- Non-cash expenses
Each of the above adjusting entries are used to match revenues and expenses to the current period. Imagine Company XYZ takes out a bank loan in October 2018 and the first repayment occurs after six months in April 2019. The company prepares its financial statements in December 2018 and needs to account for the interest expense due for the two months, November 2018 and December 2018. Although the total interest expense will not be paid until April 2019, but the company must still accrue the two months interest expense as it is incurred in the current reporting period.
This is also called the accrual accounting. The methodology states that the expenses are matched with the revenues in the period in which they are incurred and not when the cash exchanges hands.
Why are Adjusting Entries Necessary
For each category of adjusting entry, we will go into detail and investigate why these are necessary to make at the end of the accounting cycle.
This category would include both prepaid expenses and unearned revenues.
Prepaid expenses include goods or services that a company has paid for but not utilized yet. Insurance is a good example of a prepaid expense. These are prepaid for a minimum of six months. However, the company cannot take full benefit of it until the end of those six-month period. At the end of the accounting period, only expenses that are incurred in the current period are booked while the remaining is recorded under prepaid expenses.
Unearned revenues are like advance payment from the customer for services which have not yet been rendered. Therefore, in a sense, the company owes the customer and must record his as a liability for the current period rather than an income. In the next accounting period, once services have been provided to the customers for the advance payment, the company can go on to book this as a revenue.
On many occasions, a company will incur expenses but won’t have to pay them until the next period. For instance, utility expenses for December would not be paid until January. It must be booked in December irrespective of when the actual cash is paid out. Therefore, in the accounting books at the end of December, utility expense for one month is shown as a liability due.
Revenue can be accrued as well if a sale is made on account and the customer has not paid yet. For example, in December, a company makes a sale to a customer and gives him a three-month credit period to pay in full. Therefore, in the accounting books at the end of December, sales revenue would be recorded despite not being paid for.
Adjusting entries are also used to record non-cash expenses such as depreciation, amortization, etc. These are paper expenses for which there is no cash outlay. They are recorded at the end of the accounting period and closely relates to the matching principle.