The accrual concept of accounting is a requirement for the three most widely used accounting frameworks, IFRS, US and UK GAAP. So what does that mean?
Accrual Concept of Accounting vs Accruals
First of all, we should distinguish between the accrual concept of accounting and the accruals or accounts that are included in the statement of financial position or under US or UK GAAP, the Balance Sheet.
Accrual Concept of Accounting Definition
Under IFRS or the Generally Accepted Accounting Principles (Practice of the UK) Frameworks, accounts should be prepared on an accruals basis.
In other words, revenue should be recognized when earned and expenses should be recognized when incurred. Cash Receipts and Cash Payments are irrelevant.
Accrual Accounts on the other hand are liability accounts that are included under the current or the non-current liabilities section found on the balance sheet. They, of course, derive from the fact that the accounts are prepared using the Accruals Concept of Accounting but they are not “directly” related to that.
Accrual Concept of Accounting Explanations
So we established that the financial statements should be prepared on an accruals basis and not on a cash basis. This is of course applies for everything apart from the cash flow statement (which is prepared on a cash basis).
So what do we mean by saying the accrual concept of accounting? For revenue, we should recognize all the sales that were made during the year even if there was no actual cash inflow. If we make a cash sale, then we post the following journal:
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| July 31 | Bank | 100 | |
| Revenue | 100 |
However, if we make a sale on credit then revenue should also be recognized and the following entry is posted:
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| July 31 | Accounts Receivable | 100 | |
| Revenue | 100 |
Similarly, expenses are recognized in the period incurred regardless of when the cash outflow actually happened. In other words, if we incur expenses and pay with cash, then the following entry is posted:
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| July 31 | Admin Expenses | 100 | |
| Bank | 100 |
However, if the invoice is not yet paid, then the entry posted is the following:
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| July 31 | Admin Expenses | 100 | |
| Accounts Payable | 100 |
Accrual Concept of Accounting Examples
Example 1
Company XYZ has 31 December year end. Company XYZ sold shoes worth of $500,000 on the 10th of December to an important client. The shoes have been produced and have been already received by the client. The agreement was that 50% of the shoes would be paid when the were delivered and 50% after 6 months. The good were delivered on the 20th of December.
Answer: Company XYZ should recognize the sale made (fully) since the sale is complete, the goods are delivered and risks and rewards have been passed on to the supplier.
Therefore, the doubly entry is the following:
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| July 31 | Bank | 250,000 | |
| Accounts Receivable | 250,000 | ||
| Revenue | 500,000 |
Example 2
Company XYZ made also signed a contract with an other client that shoes worth of $1,000,000 would be produced and delivered during a two year period. The full amount was paid when the contract was signed.
As at the year end, Company XYZ has delivered shoes worth of $400,000.
Answer: Since the company has completed 40% of the order, the double entry should be the following:
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| July 31 | Bank | 1,000,000 | |
| Revenue | 400,000 | ||
| Deferred Revenue | 600,000 |
The concept is the same for expenses. Using the accrual concept of accounting, if the cost has been incurred during the year, it needs to be recognized even if no or if part of the payment has been made.