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What is Accrual Principle in Accounting?
The Accrual Principle is a concept in Accounting where the financial transactions are recorded during the same time period in which they occur. Note that the actual cash flow may occur at a later stage. For example, suppose a company supplies goods worth $50,000 in the first quarter of financial year, but the company receives the payment in the second quarter. In such a case, if we apply the Accrual Principle, then the company will record this financial transaction in its books in the first quarter itself.
The Accrual Principle is useful when it is important to match the revenues against the expenses when a financial transaction occurs, regardless of when the payment is received.
Why is it Necessary to Apply the Accrual Principle?
Most of the large companies do business on credit. They supply the goods and services in advance for which the payments are received over a period of time. Recording such transactions when the payment is actually received may project an inaccurate picture of the financial position.
As most of these large companies are listed entities, they have the obligation to declare their financial position every quarter, as accurately as possible. In every quarterly result, they record the revenue, the profit generated, the gross profit margin, their assets and liabilities, etc. Cash accounting is quite inefficient in measuring these factors and show how a business performed in a particular period. Cash Accounting has no provision to account for payments that will be received in future. Hence, such companies must adopt the Accrual Principle of Accounting.
When the companies need to measure their performance in a particular fiscal year or a quarter, they must record the expenses when the goods are purchased and revenues when the goods are supplied. Hence, they have to use the Accrual principle of accounting.
Accrual Accounting vs. Cash Accounting
Let us now highlight how Accrual Accounting differentiates from Cash Accounting.
In Cash Accounting, a financial transaction is recorded in the books only when the payment is processed. This is in contrast to Accrual Accounting where the actual payment for the goods and services supplied may be received later.
Accrual Accounting makes provisions to factor doubtful accounts because there is every chance of a default when the goods and services are supplied in credit.
In some cases, a company may receive the payments in advance, before supplying the goods. Accrual Accounting has provision to record such transactions as liability because the company is liable to provide the goods after receiving the payment. After the goods are delivered, the payment is moved from the liability account to the revenue account.
Cash accounting, unlike Accrual account, cannot account for future payments, hence it does not show the real financial position of a company. Cash accounting does not have the provision to recognize the sale of goods and services on credit, hence it creates an imbalance between the inventory and the sales figures.
Limitations of the Accrual Principle
In case of a default, the Accrual Principle can get complicated. Let's take an example. Suppose ABC Corp. supplies goods to XYZ Corp on credit, for which the payments are to be received in the next 90 days. ABC Corp. records this transaction in its books. Unfortunately, XYZ Corp is not able to keep its obligation and defaults on the payment. In this situation, ABC Corp has amount receivable in its books which is not going to come. This is a significant accounting problem because it presents an incorrect financial picture of the company.
Small Companies Cannot Adopt the Accrual Principle
The accrual principle is a standard accounting practice in large companies because it provides an accurate picture of the company's financial status. However, it is not so easy for small companies to adopt this method of accounting.
Cash Accounting is mostly limited to businesses that operate at a small scale and generate less revenue. When the volume of transactions increase to a significant level, cash accounting becomes quite useless, because the payments for such transactions are received over a period of time. However, Cash Accounting can be quite useful if a company wants to account for all the physical money (ready cash) available in its accounts.
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