Accrual accounting is one of the basic accounting principle and is followed all over the world. According to this principle, revenues should be recognized when they are earned, no matter payment is received or not. On the other hand, expenses are recognized when they occur, no matter payment is paid or not.
The idea behind Accrual concept is that revenues and expenses are recorded in the period to which they relate. As a result, financial statements present a true and fair view of the state of the company’s affair.
The opposite concept of accrual concept is cash basis accounting which records revenues and expenses only when cash is received or paid. As we mentioned above that accrual basis of accounting is accepted worldwide, then it enables the comparison of financial information with other competitors in the industry.
At the end of an accounting period, adjusting entries are passed to record accrual entries such as accruals of salaries, accruals of utilities and adjustments of prepaid payments.
Examples # 1
1. ABC Company sells furniture via its outlet in the city. On 29th January, 2015 it sold sofa set for $20,000 on credit terms of 10 days. Advise the treatment of this transaction.
According to the accrual concept, we need to recognize revenue in the month of December, no matter payment has been received in the month of December or not.
Debit Credit
Accounts Receivable 20,000
Revenue 20,000
When the customer pays on 8th February, 2015, the ABC accountant will pass the following journal entry:
Debit Credit
Cash 20,000
Accounts Receivable 20,000
You can see that we have recorded the revenue in January because it relate to that month. However, customer paid the amount in February.
2. The utilities expenses for the month of January are $500. But, the bill will be paid in February. Advise the treatment of the transaction.
Over the accrual basis, we will record utilities expense in the month of January. Though it will be paid in February.
Debit Credit
Utilities Expense 500
Accrued Utilities Expense 500
In February, when this bill is paid, we will pass the following journal entry:
Debit Credit
Accrued Utilities Expense 500
Cash 500
3. ABC Company paid advance rent $6,000 for 06 months to the owner of the office premises on 1st January, 2015. The company prepares its quarterly accounts on a regular basis. Advise the treatment in the accounts of the company.
On 1st January, the ABC accountant will pass the following entry to record the advance which is a current assets over the accrual basis of accounting.
Debit Credit
Advance Rent 6,000
Cash 6,000
On 31st March, the following rent expense entry will be passed to record the 03 month rent expense. This will be a adjustment to the recorded Advance rent amount which is part of the current assets of the company.
Debit Credit
Rent Expense 3,000
Advance Rent 3,000
Example # 2
F7 Company purchases insurance policy on 1st January 2016 and for this paid $12,000 as premium. If F7 follows the cash basis of accounting, it will record all premiums as an expense in the month of January. But when it does so, the financial performance between months cannot be compared. So, financial statements prepared over cash basis of accounting will depict unfair view of the financial position. In order to make financial statement comparable and true & fair, accountant has to follow accrual basis of accounting. It means that $12,000 premium will be distributed evenly in whole 12 months. Every month, proportionate amount is charged in insurance premium head and an equal reduction will be done in the prepaid insurance head.
Journal entries
|
Debit |
Credit |
|
|
Prepaid insurance |
12,000 |
|
|
Cash |
12,000 |
|
|
Insurance expense |
1,000 |
|
|
Prepaid insurance |
1,000 |
Example # 3
Zeta Plc has received advance payment for a construction project for which it has given pricing of $50 million on 1st Feb 2016. The project will be completed in 02 month time period. Explain how this transaction would be recorded in accrual basis of accounting.
Solution
Under the accrual basis of accounting, revenue is recognized when the service or good is rendered or supplied. Here, as the revenue amount is received before rendering/ providing services/ products, we cannot recognize this as revenue. As a result, it would be recorded as unearned revenue and displayed in current liabilities of the Zeta Plc.
However, at the end of Feb and March, the unearned liability is reduced and the corresponding figure is credited into revenue head.
Journal Entries
|
Date |
Description |
Debit |
Credit |
|
1st Feb |
Cash |
50,000,000 |
|
|
Unearned revenue |
50,000,000 |
||
|
28th Feb |
Unearned revenue |
25,000,000 |
|
|
Revenue |
25,000,000 |
||
|
25th Mar |
Unearned revenue |
25,000,000 |
|
|
Revenue |
25,000,000 |