Accrual method

The accrual principle is an accounting concept that requires that economic transactions be recorded in the time period in which they occur, regardless of when the actual cash flows for the transaction are received. The idea behind the accrual principle is that financial events are properly accounted for by matching income and expenses when transactions - such as a sale - occur, rather than when the actual payment for the transaction can be collected.

Following the accrual basis of accounting gives a more accurate picture of a company's true financial state, but is a more expensive method for small businesses to adopt.

The importance of the accrual principle

The accrual accounting method came into use as a response to the increased complexity of business transactions. Large companies that sell goods on credit can continue to receive income for an extended period of time from goods that have previously been sold. Recording such transactions when payments occur would reflect an inaccurate picture of a company's financial position, while the financial markets require timely and accurate reporting of a company's finances. With accrual accounting, large companies can present a more accurate picture of their financial position.

When a business wants to examine its actual performance during a specific time period, such as a quarter or a fiscal year, the accrual accounting method is a useful tool. It is based on the matching principle, where revenues are recorded for the period in which the goods and services are delivered, and expenses are recorded when the goods and services are purchased (thus the revenues earned match the expenses incurred during the same accounting period).

One of the reasons that accrual accounting can provide a more accurate picture of a company's performance over a specific time period is that future income and expenses can be accounted for. Financial information recorded on an accruals basis allows the company to calculate key financial indicators such as gross margin, operating margin, and net income.

The two models at the origin of the accrual principle

The concept that led to the definition of competence derives from two different logics of thought:

• the closed-cycle model
• the unfolding cycle model

The closed-cycle model

The closed-cycle model arises from the union of the principle of competence with the principle of reasonableness and the principle of prudence.

According to the principle of reasonableness, the assets and liabilities entered in the income statement must prove to be reliable and reasonable, also showing a high degree of verifiability.

According to the principle of prudence, presumed losses rather than expected profits should always be calculated and entered into the income statement. In this case, the assets must be accounted for at purchase or production cost, while the liabilities must be calculated based on the original value or the presumed settlement value.

This type of model was developed to ensure a maximum level of capital preservation for a company.

Cycle model in progress

This model favors all the transactions that occurred during the entire period of the accounting year, specifically analyzing the accounting movements that have generated wealth or that have caused losses.

The purpose of this model is to draw up an income statement that is as faithful to reality as possible. For companies operating in an international environment, the concept of fair value is the yardstick that is applied for the recording of assets and liabilities in the income statement.

The values appear to be much closer to the financial reality of the company, showing the economic trend under a more dynamic perspective that follows the volume of the company's turnover.

The writings of settlement

The accrual principle detaches itself from the financial aspect of the company to concentrate mainly on the economic one.

I can register a revenue or a cost even before having collected or paid the respective amount. And at the same time, I may have already collected or paid a certain amount without having accounted for it as income or expense.

For this reason, the accrual principle has given rise to accounting records to bridge the gap between the financial and economic aspects.

Writings in settling are divided into integration writings and rectification writings.

Rectification writings

The adjustment entries express account values that materialized financially during a financial year, but which were not actually realized and which are therefore the result of accrual in the subsequent financial year. In other words, the adjustment entries correspond to a set of information regarding costs that will have to be deferred to a subsequent year..

The rectification writing contain information on:

• Rediscounts;
• Inventories;
• Capitalization of costs, to which all costs incurred for the internal construction of assets are subject;
• Devaluation and revaluation of fixed assets.

Integration writings

The integration entries express account values that have actually occurred during a financial year, but which have not yet materialized financially. However, given that these values have already actually occurred, they must be added to the balance sheet for the current year and not to that of the following year.

In other words, the adjustment entries correspond to a set of information regarding costs and revenues that will manifest themselves financially in the following year, but, since they have already been collected, they must be accounted for in the current year.

Integration writings contain information:

• the recognition of interest income and expense accrued, but not yet paid;
• the detection of accrued income and expenses;
• the detection of invoices to be issued and received;
• the establishment and adjustment of expense funds and risk funds.

Advantages of Accrual method

The accrual method of accounting provides businesses with several advantages. These include:

• Greater accuracy - By recognizing expenses and revenue in the period they are incurred or earned, the accrual method ensures that financial statements provide a more accurate picture of the company’s financial position.
• Easier budgeting - By recognizing expenses and revenue in the period they are incurred or earned, organizations can more accurately plan and budget for future expenses and revenue.
• Allows for more informed decision-making - By accurately recording transactions in the period they are incurred or earned, the accrual method allows business owners and managers to make more informed decisions.
• Easier comparison - By recognizing expenses and revenue in the period they are incurred or earned, comparisons between businesses and across different periods are easier and more accurate.

Limitations of Accrual method

The accrual method of accounting has certain limitations that can affect the accuracy of a company’s financial statements:

• Estimation: The accrual method requires that estimates be made when calculating revenues and expenses, which can lead to inaccurate results if the estimates are not accurate.
• Timing: Revenue and expenses can be recorded in the incorrect time period, resulting in financial statements that do not accurately reflect the company’s performance.
• Complexity: The accrual method is more complex than the cash method, requiring more knowledge and expertise to understand and interpret the financial statements.
• Cash flow: The accrual method does not take into account the current or future cash flow of the company, which can be important for decision-making.
• Non-cash transactions: Non-cash transactions such as depreciation and amortization are recorded under the accrual method, which can lead to an inaccurate view of the company’s financial position.

Other approaches related to Accrual method

The accrual principle is a cornerstone of accounting, but there are several other approaches related to it that are also important to consider. These include:

• The Cash Basis Method: This method records transactions only when cash is received or paid out. This is the opposite of the accrual principle, as it does not match income and expenses when transactions occur, but rather when cash is collected or paid.
• Matching Principle: This principle states that expenses incurred to generate revenue should be recognized in the same accounting period in which the revenue is earned. This is closely related to the accrual method, as it helps to ensure accuracy in financial reporting.
• Conservatism Principle: This principle states that accountants should be cautious when recognizing revenue and expenses. This approach is used to ensure that assets and liabilities are not overstated or understated, as this could lead to inaccurate financial reports.

In summary, the accrual principle is an important accounting concept that requires that economic transactions be recorded in the period in which they occur. There are several other approaches related to this principle, such as the cash basis method, the matching principle, and the conservatism principle, which help to ensure accuracy and consistency in financial reporting.

Footnotes

Accrual method — recommended articles

Time period concept — Accounting Convention — Periodicity concept — Opening balance — Accounting concepts — Comparative statements — Opening balance sheet — Accrued income — Accounting Principles — Extraordinary Item

References

• Horngren C., Harrison W., Oliver S., Best P., Fraser D., Tan R., Willett R. (2012). Accounting. Pearson Higher Education AU.
• Needles B., Powers M., Crosson S. (2013), Principles of Accounting. Cengage Learning.
• Weil R., Schipper K., Francis J. (2013), Financial Accounting: An Introduction to Concepts, Methods and Uses. Cengage Learning.

Author: Alice Nicoletti