Accrual accounting

There are two basic type of accounting methodologies – one is cash accounting and the other is accrual accounting. Accrual accounting depicts the effects of transactions and other events and circumstances on a reporting entity’s economic resources and claims in the periods in which those effects occur, even if the resulting cash receipts and payments occur in a different period. IFRS requires using accrual accounting (IAS 1 27). Accrual accounting is more complex than cash accounting, cash accounting may sometimes be used for tax return accounting for small businesses.

This is important because information about a reporting entity’s economic resources and claims and changes in its economic resources and claims during a period provides a better basis for assessing the entity’s past and future performance than information solely about cash receipts and payments during that period. 


The accrual basis of accounting records income and expenses when they are earned.

This accounting method records receivables as income from the moment the service or goods are delivered, and records payables as expenses from the moment the expense is incurred, regardless of when money is received or paid. The accrual basis of accounting is the best method to represent an entity’s financial position since it does a better job at matching income with expenses (matching principle).

Financial reporting divides the economic life of a business into artificial time periods, such as a year, a quarter or a month.


Use of estimates

The accrual basis requires the use of estimates in certain areas. For example, a company should record an expense for estimated bad debts that have not yet been incurred. By doing so, all expenses related to a revenue transaction are recorded at the same time as the revenue, which results in an income statement that fully reflects the results of operations. Similarly, the estimated amounts of product returns, sales allowances, and obsolete inventory may be recorded. These estimates may not be entirely correct, and so can lead to materially inaccurate financial statements. Consequently, a considerable amount of care must be used when estimating accrued expenses.

The practical application of the accruals principle leads to the necessity of making the estimates of the following nature:

  • Accrued depreciation of fixed assets;
  • Accrued amounts for the write-off of intangible assets;
  • Provisions for doubtful debts.

Financial closing entries

In closing the accounting records to prepare (interim) financial reports, consolidation returns or (audited and/or consolidated) financial statements adjusting entries are recorded.

Adjusting entries are made to:

  • Ensure that the revenue recognition and expense recognition principles are followed
  • Required every time a company prepares financial statements
  • Includes one income statement account and one balance sheet account

Types of Adjusting Entries *

Deferrals:
1. Prepaid expenses: Expenses paid in cash and recorded as assets in the reporting period before they are used or consumed.
2. Unearned revenues: Cash received in the reporting period before service are performed.

Accruals:
1. Accrued revenues: Revenues for services performed in the reporting period but not yet received in cash or recorded.
2. Accrued expenses: Expenses incurred in the reporting period but not yet paid in cash or recorded.

*ADJUSTING ENTRIES NEVER INVOLVE CASH

Example accrual accounting and cash accounting

An small example of cash accounting (with the IFRS accrual accounting in brackets) is as follows:

If your company ABC receives an order to supply 10 computers on October 10, but you deliver the goods in November, the sale will be recorded in the month of November only and not in the month of October.

Your firm ABC receives cash of €8,000 for the sale of 10 computers from company XYZ on November 10. The accountant will record the transaction of a sale on November 10 only, and not on October 10 (which it would be recorded based on accrual accounting).

Companies record expenses when they are actually paid out. Let’s understand the concept with the help of an example. If your company hires a contractor on November 1 and a bill is raised on that day, but the actual money was paid out on November 15.

Under cash accounting, November 15 would be the date when the transaction will be recorded and not November 1st (which it would be recorded based on accrual accounting).


Accrual accounting

Accrual accounting

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