Financial statements must be prepared under the accrual basis of accounting. Cash basis of accounting must not be used. Accrual basis of accounting is a basic accounting concept that direct us to record income in the period at which it is earned. Similarly, it guides us to record expenses in the period at which it is incurred. This period is not necessarily the period at which cash is paid for the expenses. We will first discuss the definition of accrual basis of accounting and then its effects on both incomes and expenses with examples.
What is the Accrual Basis of Accounting?
Accrual basis of accounting states that:
- Incomes must be recorded in the period at which it is earned rather than the period in which cash is received, and
- Expenses must be recorded in the period in which it is incurred rather than the period in which cash is paid.
What is the effect of the Accrual Basis of Accounting on Incomes?
As discussed earlier, incomes must be recorded in the period in which it is earned. This concept of accruals give rise to two types of incomes:
Incomes which are earned in the current period, but cash has not been received yet. Cash might be received in the subsequent period. Accrued income is recorded as a current asset in the financial statements. This is the application of accrual basis of accounting because we record such incomes when we earn it, rather than when cash is received.
Incomes which are not earned yet, but cash has been received in the current accounting period are called prepaid incomes. You already know that under accrual basis, incomes are recorded when they are earned, in this case, we have not earned any income yet, but we have received cash for this. Therefore, we do not record it as an income, we record it as a current liability.
Example of Prepaid Income:
Marvel Ltd deals in selling gift items. Suppose, they received a cash amount of $500 from a customer at 29th December 2019 and wants the gift to be delivered at 10th Jan 2020. Now, Marvel Ltd has not sold any gifts yet, but it had already received the cash for it. Under the accrual basis of accounting, it must record the cash received as a Prepaid income (Current liability). When it delivers the gifts on 10th January 2019, then it should reverse the entry and should record it as an income.
What is the effect of Accrual Concept on Expenses?
The concept of accruals has given birth to two kinds of expenses:
Expenses which are incurred in the current accounting period, but cash has not been en paid yet are called accrued expenses. Such expenses are recorded as current liabilities in the balance sheet. You can see, we have not paid any cash yet, still, we are recording these expenses, this is entirely due to the accrual basis.
Example of Accrued Expense:
Marvel ltd has a contract with its supplier under which Marvel ltd pays only after 60 days of receiving the inventory. Suppose Marvel ltd received inventory worth $5,000 on 25th December 2019. Under the contract, Marvel Ltd will pay on 23rd February 2020. Therefore, it will record this expense as an accrued expense in the financial statements for the year ended 31st December 2019.
Expenses for which payment has been made in advance prior to the incurring of actual expense are called prepaid expenses. Prepaid expenses must not be shown as an expense in which it is paid, rather it should be recorded as a current asset.
Examples of Accrual Basis of Accounting:
- Sales are recorded in the same period they are made i.e. the period at which cost of sales is incurred.
- Expenses are recorded in the profit or loss statement in the same period as they arise and not in the period at which they are paid.
- Incomes are recorded in the profit or loss statement in the same period as it is earned and not in the period in which cash is received.
Accrual Basis of Accounting Vs Cash Basis of Accounting
Cash basis of accounting tells us to
- record the income when cash is received, and
- record the expense when cash is paid.
Whilst as discussed earlier, the accrual basis of accounting tells us to
- Record the income when it is earned, and
- Record the expense when it is incurred.
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