Accrual concept is the most fundamental principle of accounting which requires recording revenues when they are earned and not when they are received in cash, and recording expenses when they are incurred and not when they are paid.
GAAP (generally accepted accounting principles) requires that financial statements be prepared using the accrual basis, not the cash basis. This means revenues and expenses are recorded in the period they relate to, not when cash is received or paid. Using the accrual concept ensures that your financial reports accurately reflect your business’s net income, assets, liabilities, and retained earnings, which helps you better analyze your company’s financial performance and position over time.
At the end of each reporting period, companies make adjusting journal entries to account for any accruals. This includes things like utilities expenses, interest expenses, wages and salaries, and adjustments for prepayments.
Examples
The following examples elaborate the accrual concept.
1. An airline sells tickets in advance but does not record the money received as revenue right away because the flight (the service being paid for) hasn’t occurred yet. The revenue is only recognized when the flight takes place, and that’s when the service is actually provided. This practice follows the accrual accounting principle, ensuring that revenue is matched with the period when the service is delivered.
The airline journalizes receipt of cash as follows:
Unearned revenue is a current liability that is settled when the flight occurs.
2. An accounting firm pays $120,000 for a year’s rent on January 1 but doesn’t immediately record it as an expense since the office isn’t yet used. Instead, the payment is recorded as ‘prepaid rent,’ a current asset, and is expensed over time as the space is utilized.
The firm recognizes rent expense over the period. For example, in its quarterly income statement on March 31, it expenses three months’ rent amounting to $30,000 ($120,000/12 × 3) for the period from January 1 to March 31.
3. A business records its utility bills as soon as they are received, but not when they are paid, because the service has already been used. The company disregards the payment date in favor of accurately reflecting the expense when the service was consumed.
