The Accrual basis is the accounting principle that use to recognize and record accounting transactions or events in the financial statements regardless of its cash flow.
Under the accrual basis, expenses are recognized and recorded in the Financial Statements at the periods they are incurred rather than at the period they are paid. Revenues are recognized and recorded in the Financial Statements at times risks and rewards are transferred and received. Accrual basis is used in both US GAAP and IFRS.
Importance of accrual basis:
Now let’s start with this example to help you understand why accrual is important?
This principle assumes that to show the entity’s real performance, financial statements should be shown the real economic transactions rather than cash flow (cash basis).
The real economy here means the actual performance of the entity’s management. For example, the direction of company A will reward by its board of directors if net sales for the year 2016 reach USD 30,000,000.
So the net sales here mean the number of sales that company A sold its products during the year 2016. Part of these sales is collected from customers during the year.
But, probably there are some remaining amounts that customers still do not pay. If we use a cash basis to record sales, in this case, it does not show the actual performance of management in company A.
But if we use the Accrual Basis, the net sales will be USD 30,000,000. And that is the real economic performance.
So, this is why the accrual basis is important to the company. Now let’s see how accrual affects the balance sheet.
The balance sheet items that corresponded with incomes or expenses are records and recognized in the same way. For example, Accounts payable are records and recognized when accrual expenses are records and recognized.
The accrual basis uses many often to certain types of expenses and revenues, for the following are the areas that often deal accrual basis.
The under the Accrual Accounting Concept, the accrual amount is based on the best estimate, and there is no right or wrong balance.
Basically, accrued revenue refers to any goods or services that the entity sold or performed for its customers and has not issued an invoice or bill to its customers yet.
This is mostly happening at the end of the month or year. For example, at the end of the year, 31 December 2016, the entity delivered goods to its customers amounting to USD 50,000, but the entity did not issue invoices for these goods.
Based on an accrual basis, the entity needs to recognize this USD 50,000 as revenue in 2016 accounting records no matter it issued invoices to the customers or customers have not paid the fee yet.
Accrued revenue is one of the best examples of the accrual basis used in financial statements. The accounting transaction for accrued revenue is simple.
You need to debit account receivables if the invoice is issued or un-bill receivables if the invoice is not yet in the balance sheet and credit revenue in the income statement.
Accrual Revenue and Deferred Revenue
The accrued Revenue and deferred Revenue are different. Accrued venues refer to goods or services that the entity sold or performed to its customers but not yet billed or paid by them.
Accrued revenue is the entity’s assets. However, deferred revenue, sometimes called unearned revenue, is a liability. It happens when the entity receives cash or similar assets in return for goods or services that the entity will be provided for in the future.
The entity cannot recognize cash or similar kind as revenue once the goods or services are not provided to the customers. Deferred revenue is also an example of the accrual basis used when the entity receives payments before providing goods or services.
Accounting records for deferred revenue are unearned credit revenue in the liabilities section and debit cash or bank or similar balance sheet.
This kind of transaction deals only with the balance sheet. When the entity performs the services or delivered goods to customers, then we need to debit deferred revenue to release liabilities and credit revenue to recognize sales revenues. No account receivable is involved in this case.
Accrued expenses are another perspective of accrued revenue. Accrued expenses happen when the entity has received goods or services from its suppliers, yet it does not receive an invoice or similar kind of bill.
The best example of accrued expenses is utility expenses. Invoices for this kind of expense are mostly received at the beginning of the following month.
Accrual Accounting VS Cash Accounting
The cash basis is different from an accrual basis. Mainly based on the time of recognition, yet the value of transactions is the same.
In order word, accrual basis and cash basis is different because of timing differences.
Under the cash basis, the expenses and revenues are recorded and recognized in the financial statements when cash is paid and received rather than occurred.
For example, salary expenses are records in FS at the time cash related to those salary expenses are paid to the employee. The two types of accounting concepts are straightforward to understand.
Example of Accrual Accounting
The following are examples of recording accounting transactions under Accrual Accounting.
If the salary expenses are paid to staff at the end of the month that service is provided, then those months’ salary expenses should be recorded immediately.
In this case, the salary expense for both concepts is the same because we record and pay in the same months.
However, if the salary expenses are paid in the following month, we have to accrual the salary expenses as follows.
The following are examples of Accrual Accounting Entries.
Dr Salary Expenses(Income Statement)
Cr Salary Expenses (Balance Sheet)
Then, at the time salary are paid:
Dr Salary Expenses (Balance Sheet)
Cr Cash/Bank (Balance Sheet)
Here is another example related to Accrue revenue.
Both concepts show the same amount of revenue in the income statement for cash sales transactions because both concepts simultaneously recognize the revenues transactions.
However, for credit sales, under the Accrual Basis, revenues and receivables are recognized at the time risks.
And rewards of those sales transactions are transferred to customers. However, if the risks and rewards are not transferred, sales are recorded as deferred Rrevenue.
For Cash Sales,
Dr Cash (Balance Sheet)
Cr Revenue (Income Statement)
For Credit Sales
Dr Receivable (Balance Sheet)
Cr Revenue (Income Statement)
Over Accrual and Under Accrual Expenses
Under Accrual Accounting, the accrual amount is based on the best estimate. And there is no right or wrong. Accrual Concept is a kind of accounting estimate as you don’t know the actual value of expenses.
If you over or under accrual, the over or under amount is adjusted prospectively. (See IAS 8).
For example, you have an accrual electricity expense amount estimated at $1,500, and the entry would like below:
Dr Electricity Expenses Amount ( Income Statement) $1,500
Cr Accrual Expense (Balance Sheet) 1,500
Then at the beginning of the month, you have received the invoice amount of $1,700. In this case, the accrual is under $200, and the transaction would like below when you make payment.
Cr Cash/Bank $1,700
Dr Accrual Expenses $1,500
Dr Electricity Expenses Amount $200
You might not need to reverse accrual to Payable, and it is not wrong. As you can see in this example, the under accrual amount is recognized as expenses in the following month, and if the accrual is for the month at the end of the year, then it is prospectively changed to the next year. (See IAS 8)
Comment below if you have any questions related to accrual accounting entry.
Written by Sinra