Business, Legal & Accounting Glossary
An accounting method that tries to match the recognition of revenues earned with the expenses incurred in generating those revenues. It ignores the timing of the cash flows associated with revenues and expenses.
A system of accounting in which revenue is recognised when they are earned and expenses as they are incurred.
The accruals concept is a basic accounting concept that is used in the preparation of both profit and loss accounts and a company’s balance sheet.
Accrual accounting differs from cash accounting, which recognises transactions when cash has been either received or paid.
When using accrual accounting methods in the preparation of an accounting periods financial statements, there will inevitably be some uncertainty or estimations involved in respect to transactions.
An accounting method that tries to match the recognition of revenues earned with the expenses incurred in generating those revenues. It ignores the timing of the cash flows associated with revenues and expenses.
With the accrual method, income and expenses are recorded as they occur, regardless of whether or not cash has actually changed hands.
An example is a sale on credit. The sale is entered into the books when the invoice is generated rather than when the cash is collected. Likewise, an expense occurs when materials are ordered or when a workday has been logged in by an employee, not when the cheque is actually written. The disadvantage of this method is that you pay tax on revenue before you’ve actually received it.
The operating section of the cash flow statement shows the firm’s performance on a cash basis. The cash flow from operations is the amount of cash that has been generated with day-to-day operations. The period in which the cash is received or paid is also the same as the period where it is included in computing the cash flow from operations. This is called cash accounting.
In practice, however, most organizations use ‘accrual accounting’. With accrual accounting, performance measurement is not solely determined by cash flows. Accounting principles such as IFRS and U.S. GAAP prescribe when revenues and expenses need to be recorded.
The income statement is based on accrual accounting. This means that it is not necessary that the cash flow is in the same period as the revenue/expense. In other words, with accrual accounting cash flows are allocated to periods. When a customer pays money to the firm, this cash inflow can be revenue in a period prior to the cash inflow, the same period, or a future period. The same holds for cash outflows: a cash outflow can be expensed in a period prior to payment, the same period, or a later period. Accounting principles (discussed next) determine the period to which the cash flow is allocated.
With accrual accounting, any possible transaction can be classified in either of six possibilities, which are shown in the figure below. In the upper half, it shows the three possible treatments of cash outflows. In the lower half, it shows the possibilities for cash inflows.
In the first column, the period of the cash flow is the same as the period of the expense/ revenue. In this column, accrual accounting yields the same result as cash accounting.
In the second column, we see deferred accruals. That means the period of the expense/revenue is in a later period than the cash flow. In the case of a cash outflow, the payment is capitalized as an asset, because it is considered to have future value. In a later period, when the asset is reduced in value, the asset is expensed. In the case of a cash inflow, a liability is increased. As the cash is received, but the firm has not delivered/rendered the products/services, the firm will have an obligation to do so. In a later period, when the firm has fulfilled its obligations, the liability is reduced and revenue is recognized. In both situations, we see that the cash flow is ‘parked’ on the balance sheet. That’s where the ‘accrual’ in ‘accrual accounting’ is coming from: cash flows accrue to the balance sheet.
The opposite situation is depicted in column three. In a period prior to the cash flow, the expense/revenue is recognized. The resulting ‘accruals’ are called ‘accrued accruals’. The term ‘accrued’ refers to the fact that the cash flow is anticipated. In the cash of an anticipated cash outflow, an expense is recognized in an earlier period. At the same time as the expense, a liability is recognized. The liability reflects the fact that the firm has an obligation, in this case, to pay money. When the money is paid, the liability is reduced, and cash is reduced. In the case of an anticipated cash inflow a revenue is booked in an earlier period than the period of the cash inflow. At the time of the revenue, an asset is recognized to reflect the fact that a customer will pay money to the firm in the future. At the time of the cash inflow, this asset is reduced (because the customer has paid), and cash increases. Again, the balance sheet is used to bridge timing differences between the time of the expense/revenue and the time of the cash flow.
Key points:
Accrual accounting is very flexible, and as a result, it is open to manipulation. However, accounting principles restrict this flexibility so that the financial statements reflect the economic reality. (Large firms have their financial statements audited by an external auditor for increased assurance that the accounting principles have been applied correctly.)
There are two main accounting principles: the revenue recognition rule determines in which period incoming cash flows need to be recognized as revenue and the matching principle tells in which period an outgoing cash flow needs to be expensed.
The revenue recognition principle states that revenues are earned in the period where the product is delivered or the service has been rendered, regardless in which period the customer pays the firm.
The matching principle states that cash outflows should be booked as an expense in the period where they help to generate revenue.
Key points:
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This glossary post was last updated: 28th November, 2021 | 0 Views.