The accruals concept, also known as the accrual basis of accounting or accrual accounting, is a fundamental accounting principle that requires businesses to record financial transactions when they are incurred or earned, regardless of when the cash related to those transactions is received or paid. This concept is based on the matching principle, which states that revenues and expenses should be recognized in the same accounting period in which they are earned or incurred.
The accruals concept aims to provide a more accurate representation of a company’s financial position and performance by reflecting its economic activities during a specific accounting period. It allows for a better understanding of a company’s true financial health and helps in making informed decisions for business management and investors.
Under the accruals concept, financial transactions are recorded as follows:
- Revenues: Recognized when they are earned, not when the cash is received. For example, a company provides services to a customer in December but doesn’t receive payment until January. Under the accruals concept, the revenue would be recorded in December, when the service was provided.
- Expenses: Recognized when they are incurred, not when the cash is paid. For example, a company receives utility services in December but doesn’t pay the utility bill until January. Under the accruals concept, the expense would be recorded in December, when the utility services were used.
The accruals concept contrasts with the cash basis of accounting, which records financial transactions only when cash is received or paid. While the cash basis of accounting is simpler, it can be less accurate in reflecting a company’s financial performance, as it doesn’t take into account the timing of revenue recognition and expense incurrence.
Example of the Accruals Concept
Let’s consider a hypothetical example to illustrate the accruals concept in practice.
Imagine a company called “Blue Ocean Consulting” that provides marketing consulting services. The company follows the accrual basis of accounting. In December, Blue Ocean Consulting provided services to a client and sent an invoice for $10,000. However, the client will not pay the invoice until January of the following year.
At the same time, Blue Ocean Consulting used office supplies worth $2,000 in December but didn’t pay for them until January.
Here’s how the transactions would be recorded under the accruals concept:
- Revenues: Blue Ocean Consulting provided services in December, so the revenue should be recognized in December, even though the payment will be received in January. The journal entry in December would be:Debit: Accounts Receivable – $10,000 Credit: Service Revenue – $10,000This entry records the earned revenue and increases the Accounts Receivable account, indicating that the company expects to collect the payment in the future.
- Expenses: Blue Ocean Consulting used office supplies in December, so the expense should be recognized in December, even though the payment will be made in January. The journal entry in December would be:Debit: Office Supplies Expense – $2,000 Credit: Accounts Payable – $2,000This entry records the incurred expense and increases the Accounts Payable account, indicating that the company has an obligation to pay for the office supplies in the future.
By applying the accruals concept, Blue Ocean Consulting ensures that its financial statements accurately reflect the company’s financial performance for the accounting period, providing a more accurate representation of its financial position and facilitating informed decision-making for business management and investors.