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What is the accruals concept?

Under the accruals concept, transactions are recognized, recorded and reported in the period in which they occur and not when cash is received or paid.

This concept applies to both expenses and revenues. Expenses are reported in the period in which they are incurred in earning the revenues. When a sale transaction has been completed, it is recognized as earned revenues. Expenses and revenues are therefore not dependent on when the cash is paid for the expenses or received from the sale for them to be recognized as such.

For example, you made purchases worth $5,000 and you have paid $3,000. Should your suppliers close their accounts by recording their income as $3,000 for the cash received or should it be $5,000? Based on this accruals concept, $5,000 should be taken up as the purchase transaction for the period, at the end of which the $2,000 is accrued if it still remains unpaid. When the $2,000 is received after the end of the accounting period, it is not revenue but treated as cash receipt. To the suppliers, their cash asset increases by this amount and the asset of debtors decreases by the same amount.

All earnings and expenses that occur in a period must be reported in the period so that the income and profit or loss for the period can be determined. A good example is sale made on credit. Once the goods are delivered to the customers, the revenues are recognized as having been earned even though cash payments have not been received and may only be received 30 days later which is the allowed credit period. This is also known as accrued revenue.

Another example, let’s assume that a company has been late with the rent. At the end of the financial year, the rent is two months in arrears. The monthly rent is $400 which means the company has paid only $4,000 in rent instead of $4,800 for the year. In the following year, the company pays up all the rent which amounts to $5,600 ($800 in arrears + whole year’s rent of $4,800). The question arises as to how much should the rent be in each of the two years. If we use the cash payment basis, one year the rent is $4,000 and the next year, the rent is $5,600. Using the accrual basis, the rent should be equal that is $4,800 in each of the two years. It is obvious that using cash basis for recognition of expenses will understate income in one year and inflate the income in another year.


Last Updated (Sunday, 05 December 2010 15:37)