What is the Accrual Principle? The accrual principle is an accounting concept that requires accounting transactions to be recorded in the time period in which they occur, regardless of the time period when the actual cash flows for the transaction are received. The idea behind the accrual principle is that financial events are most properly recognized by matching revenues against expenses when transactions – such as a sale – occur, rather than when the actual payment for the transaction may be received.
Following the accrual principle in accounting provides a more accurate picture of the actual financial status of a company, but it is an expensive method for small businesses to adopt.
GAAP and IFRS on the Accrual Principle
The accrual concept is considered to be standard accounting practice for large companies and is supported by both the International Financial Reporting Standards (IFRS) and the Generally Accepted Accounting Principles (GAAP). These accounting frameworks provide guidelines to businesses around the world on how to account for revenues and expenses apart from just using cash receipts.
Large businesses consider the accrual principle the most valid accounting system for determining the financial position and cash flows of their business operations, with revenues and related expenses recorded within the same reporting period. Businesses earning over $5 million in revenues are required to use the accrual principle for tax purposes.
Accrual Accounting vs. Cash Accounting
The main difference between accrual accounting and cash accounting lies in the period in which revenues and expenses are recorded as having occurred.
Accrual accounting method
The accrual method of accounting is based on matching revenues against expenses in the period in which the transaction takes place, instead of when the payment is processed, which is the procedure with cash accounting. The accrual method requires businesses to factor in a “non-payment allowance” since goods are delivered to customers prior to payments being received, and some customers may fail to pay.
On the other hand, some customers may pay for the goods before the goods are delivered to the purchaser. In such an instance, the payment is initially recorded as a liability for the seller (because, having received the payment, the business is then liable for delivering the goods). When the goods are delivered to the customer, the payment is transferred from the liability account to the revenue account. Similarly, when an expense bill is received, it is recorded in the expense account as such, even before payment for the expense is made.
Cash accounting method
The cash accounting method records revenue and expense transactions when the payments are physically received or paid out. This method is restricted to small businesses that do not have significant volumes of transactions. The advantage of this method over the accrual method of accounting is that a business can account for all the physical money it has on hand.
However, if the business sells goods on credit through internal financing, then it would be unable to account for the future payments, since cash accounting, unlike the accrual accounting method, does not have a means of recording future payments. Therefore, a business that uses the cash accounting method may not always present the most accurate view possible of its real financial position.
The Need for the Accrual Principle
The complexity of business transactions
The accrual method of accounting came into use as a response to the increased complexity of business transactions. Large companies that sell goods on credit may continue to obtain revenue over a long period of time from goods that were sold earlier. Recording such transactions when the payments occur would reflect an inaccurate picture of the company’s financial position, whereas the financial markets require timely and accurate reporting of a company’s finances.
With the accrual accounting method, large businesses can present the most accurate picture of the financial position of the company.
Measuring the performance of a business in a particular period
When a business wants to examine its actual performance during a specific period of time – such as a quarter or one fiscal year, the accrual method of accounting is a useful tool. It is based on the matching principle, where revenues are recorded for the period when goods and services are delivered, and expenses are recorded when goods and services are purchased (thereby matching revenues earned against expenses incurred during the same accounting period). One reason accrual accounting is able to provide a more accurate overview of a business’ performance over a specific time period is that future revenues and expenses can be accounted for. All The Best! 2020
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