Accrual Principle - Explained
What is the Accrual Principle?
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Table of ContentsWhat is the Accrual Principle?How does the Accrual Principle Work?The Process of Recording Transactions under the Accrual PrincipleAccrual Accounting vs. Cash AccountingAcademic Research for Accrual Principle
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.
Academic Research for Accrual Principle
- Accounting earnings and cash flows as measures of firm performance: The role of accounting accruals, Dechow, P. M. (1994). Accounting earnings and cash flows as measures of firm performance: The role of accounting accruals. Journal of accounting and economics, 18(1), 3-42.This paper investigates circumstances under which accruals are predicted to improve earnings ability to measure firm performance, as reflected in stock returns. The importance of accruals is hypothesized to increase (i) the shorter the performance measurement interval, (ii) the greater the volatility of the firms working capital requirements and investment and financing activities, and (iii) the longer the firms operating cycle. Under each of these circumstances, cash flows are predicted to suffer more severely from timing and matching problems that reduce their ability to reflect firm performance. The results of empirical tests are consistent with these predictions.
- The market pricing of accruals quality, Francis, J., LaFond, R., Olsson, P., & Schipper, K. (2005). The market pricing of accruals quality. Journal of accounting and economics, 39(2), 295-327.We investigate whether investors price accruals quality, our proxy for the information risk associated with earnings. Measuring accruals quality (AQ) as the standard deviation of residuals from regressions relating current accruals to cash flows, we find that poorer AQ is associated with larger costs of debt and equity. This result is consistent across several alternative specifications of the AQ metric. We also distinguish between accruals quality driven by economic fundamentals (innate AQ) versus management choices (discretionary AQ). Both components have significant cost of capital effects, but innate AQ effects are significantly larger than discretionary AQ effects.
- Application of accrual accounting in the Australian public sectorrhetoric or reality, Guthrie, J. (1998). Application of accrual accounting in the Australian public sectorrhetoric or reality. Financial accountability & management, 14(1), 1-19.This paper presents a contextual. historical analysis of recent accrual accounting developments in the Australian Public Sector (APS). It takes a critical stance in that it questions the accrual accounting developments on a number of grounds. The paper examines changes in public sector financial management and accountability in four distinct settings, being: accrual financial reporting, accrual management systems, whole of government reporting, and accrual based budgeting. The findings show that already in Australia accrual accounting has made significant encroachments into some areas of annual financial and budget reporting. This influx has meant that terms such as deficit, debt, liabilities, operating results, assets, etc. have begun to change in meaning, which it is argued has important implications for the current process of transformation of aspects of the APS.
- On Comparing Cash Flow and Accrual Accounting Models for Use in Equity Valuation: A Response to Lundholm and O'Keefe (CAR, Summer 2001)*, Penman, S. H. (2001). On comparing cash flow and accrual accounting models for use in equity valuation: A response to Lundholm and O'Keefe (CAR, Summer 2001). Contemporary Accounting Research, 18(4), 681-692.A claim is commonly made that cash flow and accrual accounting methods for valuing equities must always yield equivalent valuations. A recent paper by Lundholm and O'Keefe 2001, for example, claims that, because of this equivalence, there is nothing to be learned from empirical comparison of valuation models. So they dismiss recent research that has shown that accrual accounting residual income models and earnings capitalization models perform, over a range of conditions, better than cash flow or dividend discount models. This paper demonstrates, with examples, that the claim is misguided. Practice inevitably involves forecasting over finite, truncated horizons, and the accounting specified in a model cash versus accrual accounting in particular is pertinent to valuation with finitehorizon forecasting. Indeed, the issue of choosing a valuation model is an issue of specifying pro forma accounting, and so, for finitehorizon forecasts, one cannot be indifferent to the accounting.
- Earnings management, Schipper, K. (1989). Earnings management. Accounting horizons, 3(4), 91.
- Accrual accounting in the public sector: experiences from the central government in Sweden, Paulsson, G. (2006). Accrual accounting in the public sector: experiences from the central government in Sweden. Financial Accountability & Management, 22(1), 47-62.
- The pricing of earnings and cash flows and an affirmation of accrual accounting, Penman, S. H., & Yehuda, N. (2009). The pricing of earnings and cash flows and an affirmation of accrual accounting. Review of Accounting Studies, 14(4), 453-479.Under accrual accounting, earnings add to shareholders equity. Cash flow generated by a business has no effect on the book value of shareholders equity but reduces the book value of net assets employed in business operations. In short, accrual accounting rules prescribe that earnings add to shareholder value, but cash flow is irrelevant to the valuation of equity. This paper documents that the stock market prices equity shares according to this prescription. Earnings are priced positively but, given earnings, a dollar more of free cash flow from a businesscash flow from operations minus cash investmentis, on average, associated with approximately a dollar less in the market value of the business and has no association with changes in the market value of the equity claim on the business. Furthermore, controlling for the cash investment component of free cash flow, cash flow from operations also reduces the market value of the business dollar-for-dollar and is unrelated to the changes in market value of the equity.
- The changing time-series properties of earnings, cash flows and accruals: Has financial reporting become more conservative?, Givoly, D., & Hayn, C. (2000). The changing time-series properties of earnings, cash flows and accruals: Has financial reporting become more conservative?. Journal of accounting and economics, 29(3), 287-320.
- Accounting accruals and auditor reporting conservatism, Francis, J. R., & Krishnan, J. (1999). Accounting accruals and auditor reporting conservatism. Contemporary accounting research, 16(1), 135-165.Accounting accruals are managers' subjective estimates of future outcomes and cannot, by definition, be objectively verified by auditors prior to occurrence. This causes audits of highaccrual firms to pose more uncertainty than audits of lowaccrual firms because of potential estimation error and a greater chance that highaccrual firms have undetected asset realization and/or going concern problems that are related to the high level of accruals. One way that auditors can compensate for this risk exposure is to lower their threshold for issuing modified audit reports, an action that will increase modified reports and, therefore, lessen the likelihood of failing to issue a modified report when appropriate. We call this auditor reporting conservatism and test if highaccrual firms in the United States, are more likely to receive modified audit reports for asset realization uncertainties and going concern problems. Empirical results for a large sample of U.S. publicly listed companies support the hypothesis that auditors are more conservative, that is, more likely to issue both types of modified audit reports for highaccrual firms. Further analyses show that incomeincreasing accruals are somewhat more likely to result in reporting conservatism than incomedecreasing accruals, and that only the Big Six group of auditors show evidence of reporting conservatism. These findings add to our understanding of the audit report formation process and the potentially important role played by accounting accruals in that process.
- Elements of a theoretical framework for public sector accounting, Pallot, J. (1992). Elements of a theoretical framework for public sector accounting. Accounting, Auditing & Accountability Journal, 5(1).Suggests a notion of community assets based on common property that recognizes the fundamental importance of accountability and democratic control over resources in the public sector, the sociopolitical nature of accounting, and the need to give visibility to public as well as private interests. The development of such a concept has immediate effects on the way the accounting entity and the relationship between government and society are viewed and may even have ramifications for accounting in the private sector.
- Accrual accounting and equity valuation, Ohlson, J. A., & Zhang, X. J. (1998). Accrual accounting and equity valuation. Journal of Accounting Research, 36, 85-111.