The Accrual Principle in Accounting

 

Please Note: This article is part of a series of articles titled Accounting and Bookkeeping Principles for Contractors
Written by James R. Leichter

The Accrual Principle

The measure of business income is the most important function of accounting. Income measures the change in equity associated with business operations for a specific period of time. Some changes in equity are obvious: If the business pays $200 cash in January for computer repairs completed in January, its assets and equity each decrease in January. In other words, Cash was credited by $200 and an equity account was debited by $200. A debit to equity is an expense—in this case, a Repairs Expense. Since the transaction affected equity, it also affected income.

A change in cash, however, is not necessarily associated with a change in equity. If a business pays $2,000 cash for equipment, Cash decreases by $2,000 and another asset account, Equipment, increases by $2,000. Since the asset total was unchanged, there was no change in equity and no effect on income. Similarly, the payment of an amount owed to a vendor does not affect equity: It decreases Cash and Accounts Payable equally. Furthermore, a cash contribution to capital, called Paid-in Capital, increases equity but is not associated with operations so it does affect income or appear on the Income Statement.

Some expenses are not accompanied by a decrease in cash in the same accounting period, and some revenues do not increase cash in the same period in which they were incurred. The accrual principle establishes the conventions for recording these types of expenses and revenues in accordance with the fundamental Assets = Liabilities + Equity rule.

Accrual Principle: Expenses

A cash disbursement and related expense can occur in different accounting periods under two circumstances:

  1. The cash disbursement is made prior to the incurrence of the expense. When the cash is paid out, an asset account called Prepaid Expenses is created.
  2. The cash disbursement is made after the expense is incurred. At the time the expense is incurred, a liability account called Accrued Liabilities is created.

Prepaid Expenses

A prepaid expense is created when an expense has been paid for before it has been incurred. For example: In January, Pro-USA Service paid $900 cash for a supply of gasoline that it will use to fuel its fleet of vehicles for the next several months. In that same month, Cash decreased by $900 and the asset account Gasoline increased by $900. Overall, there was no decrease in equity or expense. The entry for January would be:

Dr. Gasoline                                                         900

Cr. Cash                                                                                900

The expense part of the gasoline purchase occurs in the months when the gasoline is used. If $400 of the gasoline was used in February, $300 in March, and $200 in April, then each of these amounts is debited to the Gasoline expense account in their respective months. The entry for February is:

Dr. Gasoline Expense                                        400

Cr. Gasoline Inventory                                        400

The Gasoline asset account is credited and the Gasoline expense account is debited each month. The effect on the Balance Sheet and on the Income Statement in each month is as follows:

Gasoline Expense               Gasoline Asset, End of Month

January                                 $         0                                       $          900

February                                     400                                                    500

March                                          300                                                    200

April                                             200                                                         0

Any asset used in future periods is recorded according to the accrual principle for expenses. For example, the purchase of insurance protection creates an asset, Prepaid Insurance. As the insurance protection expires, the Prepaid Insurance account is credited and the Insurance expense account is debited. Buildings, equipment, furniture, and other long-lived assets also become expenses over future periods, but are recorded differently than short-lived expenses. See Depreciation on page 22 for more information.

Accrued Liabilities

An accrued liability is created when an expense is incurred prior to the period in which the cash is paid. For example: Employees earn $1,000 in January but are not paid until February, resulting in an expense of $1,000 in January and a liability, Accrued Salaries, at the end of January. In February, when employees are paid, the Accrued Salaries account is debited by $1000, canceling the liability:

In January:

Dr. Salaries Expense                                          1,000

Cr. Accrued Salaries                                           1,000

 

In February:

Dr. Accrued Salaries                                           1,000

Cr. Cash                                                                                1,000

Accrual Principle: Revenues

Like expenses, revenues are not always earned in the period in which the related cash for them is received. A business can earn revenues prior to, in the same period as, or after the period in which the cash is received. If revenue is earned in the same period, as with the sale of goods for cash, the entry is a straightforward debit to Cash and a credit to Sales Revenue. The other revenue scenarios require the accrual principle. Revenue received after the receipt of cash is called deferred revenue and revenue received prior to the receipt of cash is called accounts receivable.

Deferred Revenue

Contractors may collect money for service agreements before any work is actually done. For example: If cash is received in January for work performed in February, then Cash is debited and a liability account, Deferred Service Agreement, is created and credited for the cash amount in the January Balance Sheet:

In January:

Dr. Cash                                                                                600

Cr. Deferred Service Agreements                                   600

In February, when the revenue is actually earned, the cash amount is debited to the Deferred Service Agreements account to balance the credit to Sales Revenue for the same amount:

In February:

Dr. Deferred Service Agreements                   600

Cr. Sales Revenue                                                              600

Accounts Receivable

Accounts receivable is money owed to a business for previously rendered services and/or delivered goods. When a service is performed on credit, the business earns revenue in the month of the sale even if it receives the cash in a later period. For example: $1000 in services are rendered to a credit customer in January who has 30-day payment terms. In January, the asset account Accounts Receivable is debited for $1000 and the asset account Service Revenue is credited for $1000 :

In January:

Dr. Accounts Receivable-

Credit Customer                                                  1,000

Cr. Service Revenue                                                           1,000

 

In February, when the cash for the service is received, Cash is debited for $1000 and Accounts Receivable is credited for $1000:

In February:

Dr. Cash                                                                                1,000

Cr. Accounts Receivable-

Credit Customer                                                                  1,000

In deferred revenue situations, service or sales revenue is credited in the month of the sale and an asset account, Accounts Receivable, is created in that same month. When the customer remits payment later, Cash increases and Accounts Receivable decreases by the amount of the payment. If the credit customer does not pay for the services or goods, then a new equity account must be created to offset the incurred revenue.

Bad Debts

When a customer does not pay for rendered goods and/or services, the asset account Accounts Receivable is no longer an asset. In this situation, an expense account, Bad Debts, must be created and debited for the amount of the debt to offset the credit to the customer’s Accounts Receivable account.

Timing of Revenue Recognition

Revenue must be recognized in the period in which services are rendered or goods are delivered. “Services” include all products other than tangible goods such as rental revenue for the use of rental property, room revenue for the use of a hotel room, interest revenue for the use of money, franchise revenue for the use of a name, royalty revenue for the use of written or recorded material, tuition revenue for the use of educational resources, or dues revenue for the services provided by a club or association.

Matching Principle

When a business performs $400 in services it earns $400 in revenue, but it does not have $400 of income because the performance of the service incurred some expenses. When the same event has both a revenue element and an expense element, both elements must be matched and reported in the same accounting period. For example: A business performs $400 in services and incurs $100 in salary expenses while providing the services. The revenue and expense entries are:

For the Revenue Element:

Dr. Cash                                                                                400

Cr. Revenue-Repairs                                          400

For the Expense Element:

Dr. Salaries and Wages-Technicians              100

Cr. Cash                                                                                100

 

Profit is obtained when all expenses incurred during the provision of a service or the delivery of goods are deducted from revenue.

Please read Accounting Journals and Ledgers next.

 

Leave a Reply

Your email address will not be published. Required fields are marked *

Time limit is exhausted. Please reload CAPTCHA.