What is the Accrual Principle?

The accrual principle, also known as the accrual concept, is a concept used in accounting that mandates the recording of accounting transactions in the actual period of occurrence, rather than the period of occurrence of related cash flows. The accrual principle is formally required by accounting frameworks across the globe, such as the Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards (IFRS). It is employed by most companies (except small-cap companies that employ cash basis accounting methods) in order to prepare financial statements.

How does the Accrual Principle Work?

According to the accrual principle, the performance and position of a company should be measured by recording economic events, regardless of the time of occurrence of actual cash flows. In simpler terms, accrual accounting only considers the time when the transaction takes place, rather than the time in which the actual cash payment is made or received. Such an accounting methodology makes it possible to accumulate all information pertaining to revenue and expenses for a specified accounting period, without having to factor in the actual cash flows associated with the revenue and expenses during that accounting period. Thus, the accrual principle provides a remarkably accurate picture of a company's present financial situation. However, the expenses associated with implementing such a complex method of accounting is relatively much higher compared to cash accounting methods. There are a few conditions that need to be satisfied in order to properly utilize the accrual principle. These are:

• The revenue needs to be recorded at the time of invoicing the customer, not at the time of actual payment.
• The expenses must be recorded at the time of incurrence, not at the time of actual payment.
• An estimated amount of bad debt must be recorded at the time of invoicing the customer, and not at the time when a default by the customer seems imminent.
• The depreciation of a fixed asset must be recorded over its useful life, and should not be charged to expense in the period of purchase.
• Any commission to be paid to a salesperson must be recorded at the time when the salesperson earns it, and not at the time when the actual payment of the commission is processed.
• Wages need to be recognized in the period when they are earned, and not in the period when they are paid.

The Process of Recording Transactions under the Accrual Principle

Accounting procedures that follow the accrual principle often use an accrual journal entry to record transactions. The liabilities are recorded on the exact date on which they were received. Accountants then record all accrued expenses as accounts payable under the current liabilities section of the balance sheet. Besides, accrued expenses are also recognized as expenses in the income statement. At the time of payment of the bill, the accounts payable account of the general ledger is debited and the cash account is credited. Such an accounting procedure provides the company with an accurate picture of its expected cash inflows and outflows.

Accrual Accounting vs. Cash Accounting

Accrual accounting is essentially the conceptual opposite of cash accounting. This is because, unlike accrual accounting, cash accounting only records transactions where there is an actual flow of cash, irrespective of when the economic events surrounding the cash flows occurred. Let us consider the following example to illustrate the difference between accrual accounting and cash accounting procedures. Suppose, an automotive parts company C1 sold brake assemblies worth $10,000 to a client B1 on June 30th. B1 receives the bill and subsequently makes a full payment on July 15th. Now, there is a fundamental difference in how the above transaction will be recorded in C1s balance sheet under the cash and accrual methods. If C1 follows a cash accounting procedure, then its balance sheet will reflect a $10,000 revenue received on July 15th. On the other hand, if C1 follows an accrual accounting procedure, then its ledger will show an earned revenue of $10,000 on June 30th.