The accrual accounting is one of the important concept in accounting that is widely used and referred to. Be for understanding about accrual accounting, let see on example below.
Company ABC has paid a yearly rent in advance for US$30,000 on 01 January 2019. How would this payment shall be recorded? Shall the company record as expense 100% in January 2019?
The simple answer is ABC shall not record or recognize such rental 100% in January as the office space usage is for the whole year. Thus, ABC shall recognize as rental expense by spreading down equally on the monthly basis. Hence, such advance payment shall be recorded as prepaid rent and then recognize as expense at the end of each month.
The first entry when ABA made the payment is:
Dr. Prepaid Rent ……………….US$30,000
Cr. Cash or Bank ……………………..US$30,000
Subsequently at the end of each month, ABA shall recognize as expense as follow:
Dr. Rental Expense ………………US$2,500
Cr. Prepaid Rent ……………………….US$2,500
From the above, example, we can conclude the ABC shall not recognize expense when the cash payout incurred. Similarly, the revenue shall not be also recognized when we get paid. We need to analyses when the transaction is actually incurred or earned.
IAS 1 defines accrual as follow:
“In accrual basis of accounting, items are recognized as assets, liabilities, equity, income and expenses (refer to as elements of financial statements) when they satisfy the definitions and recognition criteria for those elements in the framework.”
This means that each company shall prepare its financial statements on the basis that the transaction is incurred for expense and earned for revenue regardless of the cash payment or cash receipt for such transactions. In other word, the economic events or transactions shall be recognized by matching revenues to expenses (the matching principle) at the time in which the transaction occurs rather than when payment is made (or received).
This concept or principle allows each entity to present its financial statements in a more accurate picture of such entity ‘s current financial condition.
International Accounting Standard Board (IASB) and other applicable IAS or IFRS adopts the accrual basis of accounting as result of increasing the need of quality of accounting information. This increasing need are especially from stakeholders because they want to see the accurate picture of each company before they can make any decision on any investment or financing.
Practical Recognition of Revenues and expenses
In this section, we will cover more on the practical recognition of revenues and expenses in normal business activities.
Prepaid or Deferred Expenses
As mentioned in the introduction above, prepaid expenses refer to any items that we make payment in advance before receiving services or benefits. Prepaid expenses include prepaid rent and prepaid insurance. In addition, we can also consider the payment of fixed assets as prepayment but normally we separate it out from the prepaid expenses.
All prepayment shall be recognized as assets and recognized as expenses when it is actually incurred.
Unearned (Deferred) Revenues
This term refers to the advance payment from customers for the providing goods or services. Unearned revenues, also called deferred revenues, are considered as liabilities not revenues.
Thus, when we receive cash in advance, we shall record such transaction as liabilities or unearned revenue account.
For example, ABC Company is a services provider on internet usage. On 01 January 2019, the company received payment in advance of US$1,200 for one year period effective from 01 January to December 2019.
In this case, when ABC receives cash payment on 01 January 2019, the company shall record such payment as unearned revenue. Then, on the monthly basis, ABC shall recognize service revenue for such internet service for US$100 per month until at the end of the year.
Accrued expenses refer to any costs or expenses that incurred but the invoice has not been received nor paid. Such expenses shall be recorded and presented in the income statement when such expenses incurred.
For example, at the end of 31 January 2019, ABC has incurred of interest expense of US$500 and not yet paid to the bank. Such payment due to be paid on 03th of the following months. Thus, ABC shall recognize such interest expense of US$500 and presents in its income statement at the end of 31 January 2019 as well as at the end of each month as per the agreed loan schedule until the loan is fully payoff.
This term refers to any services provided to customers but the entity has not billed to its customers nor received the payment for such services.
For example, ABC is a service company specialize in the equipment repair and maintenance. At the end of 31 January 2019, the company has provided and competed its service on the repair of printing machine for one client at the agreed price of US$1,000.However, the company has not issued invoice to client and the client also has not paid for such service.
Thus, under the accrual basis of accounting, ABC shall recognize as revenue for that month and presents in its income statement.
In order to reflect the accurate picture of financial condition, each entity shall recognize revenue and expense in accordance with the accrual basis of accounting where revenue is recognized when it earned and the expense is recognized when incurred regardless of receipt or payment.