The accrual principle: the rationale behind the income statement
What is the accrual principle? And what are its practical applications in accounting? This concept proves to be of vital importance for the preparation of a company's financial statements and especially for one of the accounting documents that make up a balance sheet, the income statement.
But why is this accounting principle so important? And what are the inspiring rationale behind its conception? What differences does it have with the cash principle?
In this article we will take you on a discovery of the accrual principle and its practical application within the income statement. In fact, on the basis of this principle all adjusting and settlement entries have developed.
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What is the accrual principle?
The accrual principle is an accounting concept that requires economic transactions to 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 revenues with expenses when the transactions-such as a sale-occur, rather than when the actual payment for the transaction can be collected.
Following the accrual principle in accounting provides a more accurate picture of a company's actual financial status, but it is a more costly method for small businesses to adopt.
What is the importance of 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 businesses that sell goods on credit may continue to receive income over a long period of time from goods that were previously sold. Recording such transactions when payments occur would reflect an inaccurate picture of the company's financial position, whereas financial markets require timely and accurate reporting of a company's finances.
With the accrual method of accounting, large companies can present a more accurate picture of their financial position.
Measuring a company's performance in a given period
When a company 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, in which revenues are recorded for the period when the goods and services are delivered, and expenses are recorded when the goods and services are purchased (so that revenues earned match expenses incurred during the same accounting period).
One reason that accrual accounting can provide a more accurate overview of a company's performance over a specific time period is that future revenues and expenses can be accounted for. Financial information recorded on the accrual basis allows the company to calculate key financial indicators such as gross trade margin, operating margin, and net income.
The accrual principle: the two originating models
The concept that led to the definition of accrual stems from two different logics of thought:
- the completed-cycle model
- the cycle-in-progress model
The completed-cycle model
The completed-cycle model originates from the combination of the accrual principle with the principle of reasonableness and the principle of prudence.
According to the principle of reasonableness, the assets and liabilities included in the income statement must prove to be reliable and reasonable, also showing a high degree of verifiability.
According to the principle of prudence, one should always calculate and include in the income statement assumed losses rather than hoped-for gains. In this case, assets should be accounted for at the cost of purchase or production, while liabilities should be calculated based on their original value or presumed settlement value.
This type of model was developed to ensure a maximum level of preservation of a company's capital.
Current-cycle model
This model prefers all transactions that occurred during the entire accounting year period, specifically analyzing accounting movements that generated wealth or caused losses.
The purpose of this model is to prepare an income statement that is as true to reality as possible. For companies that operate in an international environment, the concept of fair value is the yardstick used to record assets and liabilities within the income statement.
The values turn out to be much closer to the financial reality of the company, showing economic performance from a more dynamic perspective that follows the volume of the company's business.
Practical application
So let's start at the beginning: financial statements can be monthly, quarterly, semiannual, and annual or year-end, with a start and end date.
According to the accrual principle, the income statement must show all expenses and revenues that belong to the period under review, i.e., pertaining to the period.
Two separate discussions must be made for goods and services.
Let us consider a company X that has to close its operating budget for the year 2020.
Let us begin the analysis from revenues:
When a product is sold, the company records revenue in the year 2020 if the risks and rewards of that good have passed to the buyer. Simply put, I can move to record an asset if that asset has been delivered into the hands of the buyer by the end of the year 2020.
To verify the date of actual delivery, one must read the date entered inside the transport document (DDT if in Italy or CMR if international).
If, on the other hand, the company produces services, revenue can be recorded in the income statement only if the service has been completed by December 31, 2020.
For example, if we consider legal advice, the advice must be concluded by December 31, 2020.
In the case, on the other hand, of an ongoing service that is repeated over time, such as a rental, the revenue will be accounted for through a time proportion criterion.
Of course, for costs, the same methodology applies: it is only necessary to replace the word "revenue" with the term "costs."
The settlement entries
In practical application, we have only ever named costs and revenues and never receipts and payments.
The accrual principle moves away from the financial aspect of the business to focus mainly on the economic aspect.
In fact, I can record a revenue or expense even before I have collected or paid the respective amount. And at the same time I may have already collected or paid a certain amount without having recorded it as revenue or expense.
This is why the accrual principle has given rise to settlement entries to bridge the gap between financial and economic aspects.
Adjustment entries are divided into integration entries and adjustment entries.
Adjusting entries.
Adjustment entries express account values that have manifested themselves financially during a fiscal year, but have not actually been realized and thus result in accrual in the following fiscal year. In other words, adjusting entries correspond to a set of information regarding costs that will have to be deferred to a subsequent year.
Adjustment entries contain information on:
- Prepaid expenses;
- Inventories;
- Capitalization of costs, to which all costs incurred for the internal construction of assets are subject;
- Depreciation and revaluation of fixed assets.
Integration Entries
Integration entries express account values that have actually been realized during a fiscal year but have not yet manifested themselves financially. However, since these values have already been actually realized, they must be added in the current year's financial statements, not in the next year's financial statements.
In other words, adjusting entries correspond to a set of information regarding expenses 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 entries contain information about:
- the recognition of interest income and expense that has accrued but has not yet been paid;
- The recognition of accrued income and expenses;
- the recognition of invoices to be issued and received;
- the establishment and adjustment of expense and contingency reserves.
Accrual principle VS cash principle
The main difference between the accrual principle and the cash principle lies in the period in which income and expenses are recorded as occurring.
Accrual-based method
The accrual-based method is based on matching income with expenses in the period when the transaction takes place, instead of when the payment is processed, which is the typical procedure of cash accounting. The accrual method requires companies to account for "allowance for doubtful accounts" because goods are delivered to customers before payments are received, and some customers may not pay immediately.
On the other hand, some customers may pay for goods before the goods are delivered to the buyer. In that case, the payment is initially recorded as a liability for the seller (because, having received the payment, the company is then responsible 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 invoice is received, it is recorded in the expense account as such, even before the expense payment is made.
Cash basis method
The cash basis method of accounting records revenue and expense transactions when payments are physically received or paid. This method is limited to small businesses that do not have significant transaction volumes. 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 company sells goods on credit through internal financing, then it would not be able to account for future payments because cash accounting, unlike the accrual method of accounting, does not have a means of recording future payments. Therefore, a company using the cash method of accounting may not present a totally accurate view of its true financial position.
Is the accrual principle clearer to you now? Or do you still have doubts? Let us know in the comments section.
Article translated from Italian