Definition of 'Accrual Accounting'
Definition of 'Accrual Accounting'
An accounting method that measures the performance and position of a company by recognizing economic events regardless of when cash transactions occur. The general idea is that economic events are 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 method allows the current cash inflows/outflows to be combined with future expected cash inflows/outflows to give a more accurate picture of a company's current financial condition.
Accrued Revenue Accrued revenue is entered into an accounting journal once the revenue is earned regardless of whether a business has received the physical cash. For instance, if your business performs a service for a client, you have earned the revenue for that service. Before you receive the cash, the revenue is entered into an accrued revenue account. After you receive cash from your client, the accrued revenue account is decreased by the amount of cash received. Deferred Revenue Revenue deferrals are used by accountants to spread out revenue over time. For example, your business may enter into an agreement with a client to perform a service over a period of time. However, the client may pay you the entire amount for the service up front. If this occurs, you would enter the lump payment into a deferred revenue account and spread the revenue over the fiscal period. For instance, if a customer pays $100 upfront for two months of service, you would put the $100 into a deferred revenue account and subtract $50 from the account each month. The subtracted amounts would go to your company's cash holdings. Accrued Expenses Much like accrued revenue, accrued expenses are noted at the time they occur, regardless of whether your business has paid them. For example, you know that you have to pay employees at the end of the month before you actually write checks. The expense is entered into an accrued expenses account as a liability, then when your business writes employee checks, the accrued expense is zeroed out and cash assets decrease. Deferred Expenses
Deferred expenses are spread out over the period to which they apply. When you prepay expenses -- for rent or other items -- the entire sum is taken from your assets. For example, if you pay $6,000 for six months of rent upfront, you put the $6,000 into a deferred expense account and debit the account $1,000 each month for six months. Deferring expenses helps businesses keep track of their expense cash flows and gives a more accurate picture of quarterly performance.
3. Assumptions of accounting
Economic Entity Assumption Under the economic entity assumption, an economic activity can be identified to a separate entity accountable for that activity. In other words, this assumption states that businesses must keep their transactions separate from their owners, business units or other businesses transactions. For example, the business activities of the neighborhood coffee house are to be kept separate from the financial activities of its owners or managers. The financial statements for the coffee
house will only reflect the revenue and expenses for the coffee house. Thus, it is possible to compare the financial statements of this coffeehouse with its competitors reports, since these statements should be reported separately under the economic entity assumption. Important to note, a separate entity does not necessary mean a legal entity. For example, financial statements for a parent company and its subsidiaries (i.e. separate legal entities) can be presented together (i.e. consolidated financial statements). Going Concern Assumption For accounting purposes, the going concern assumption states that the financial activities of a business are assumed to be in operation for an indefinite period of time. This allows a business to operate with a view towards a long term. This is a very critical assumption as it provides that there is no short term end point in which all assets need to be sold and all debt must be paid off. Thus, the going concern assumption makes it possible to depreciate or amortize assets because we assume that businesses will have a long life. For example, if the coffee house was going to be sold, its assets would be valued at their disposal or liquidation value (sales price less expense of disposal). Under the going concern assumption, the coffee house values its assets at their original cost. As we can see, the going concern assumption is only inapplicable when business liquidation is imminent, and it should be used in all other business situations. Monetary Unit Assumption This assumption states that information in the financial statements must be expressed in monetary units. The reason is that economic activity is expressed in monetary unit, and thus, it makes sense to apply the same basis for accounting purposes. Monetary units are relevant, universally available, and understandable. Using the neighborhood coffeehouse as an example, the intrinsic value of the best coffee server cannot be valued in the financial statements, regardless of how many customers frequent the coffeehouse due to this individual. The inherent value of this person cannot be quantified in the financial statements as an asset. The monetary unit assumption also states that a stable unit of currency is to be used as the unit of record. In the United States, the US Dollar is typically the currency of choice. Important to note, accounting ignores inflation or deflation and assumes that US Dollar remains reasonably stable. For instance, no adjustments are necessary when adding 1990 dollars to 2010 dollars, unless economic conditions change dramatically (e.g. hyperinflation). Time Period Assumption This assumption allows for the division of businesses operational activities into artificial time periods for reporting purposes as determined by the business owners. The coffeehouse can record information on a daily, weekly, monthly, quarterly and yearly basis during a time frame they deem relevant. However, there is a trade-off between the accuracy (reliability) and relevancy in preparing financial statements: the more quickly a company presents financial data, the more likely such data contains errors (i.e. less reliable information).
Basic
Accounting Principle
The accountant keeps all of the business transactions of a sole proprietorship separate from the business owner's personal transactions. For legal purposes, a sole proprietorship and its owner are considered to be one entity, but for accounting purposes they are considered to be two separate entities.
Economic activity is measured in U.S. dollars, and only transactions that can be expressed in U.S. dollars are recorded. Because of this basic accounting principle, it is assumed that the dollar's purchasing power has not changed over time. As a result accountants ignore the effect of inflation on recorded amounts. For example, dollars from a 1960 transaction are combined (or shown with) dollars from a 2012 transaction.
This accounting principle assumes that it is possible to report the complex and ongoing activities of a business in relatively short, distinct time intervals such as the five months ended May 31, 2012, or the 5 weeks ended May 1, 2012. The shorter the time interval, the more likely the need for the accountant to estimate amounts relevant to that period. For example, the property tax bill is received on December 15 of each year. On the income statement for the year ended December 31, 2011, the amount is known; but for the income statement for the three months ended March 31, 2012, the amount was not known and an estimate had to be used. It is imperative that the time interval (or period of time) be shown in the heading of each income statement, statement of stockholders' equity, and statement of cash flows. Labeling one of these financial statements with "December 31" is not good enoughthe reader needs to know if the statement covers the one week ended December 31, 2011 the month ended December 31, 2011 thethree months ended December 31, 2011 or the year ended December 31, 2011.
4. Cost Principle
From an accountant's point of view, the term "cost" refers to the amount spent (cash or the cash equivalent) when an item was originally obtained, whether that purchase happened last year or thirty years ago. For this reason, the amounts shown on financial statements are referred to as historical cost amounts. Because of this accounting principle asset amounts are not adjusted upward for inflation. In fact, as a general rule, asset amounts are not adjusted to reflectany type of increase in value. Hence, an asset amount does not reflect
the amount of money a company would receive if it were to sell the asset at today's market value. (An exception is certain investments in stocks and bonds that are actively traded on a stock exchange.) If you want to know the current value of a company's long-term assets, you will not get this information from a company's financial statementsyou need to look elsewhere, perhaps to a third-party appraiser.
If certain information is important to an investor or lender using the financial statements, that information should be disclosed within the statement or in the notes to the statement. It is because of this basic accounting principle that numerous pages of "footnotes" are often attached to financial statements. As an example, let's say a company is named in a lawsuit that demands a significant amount of money. When the financial statements are prepared it is not clear whether the company will be able to defend itself or whether it might lose the lawsuit. As a result of these conditions and because of the full disclosure principle the lawsuit will be described in the notes to the financial statements. A company usually lists its significant accounting policies as the first note to its financial statements.
This accounting principle assumes that a company will continue to exist long enough to carry out its objectives and commitments and will not liquidate in the foreseeable future. If the company's financial situation is such that the accountant believes the company will not be able to continue on, the accountant is required to disclose this assessment. The going concern principle allows the company to defer some of its prepaid expenses until future accounting periods.
7. Matching Principle
This accounting principle requires companies to use the accrual basis of accounting. The matching principle requires that expenses be matched with revenues. For example, sales commissions expense should be reported in the period when the sales were made (and not reported in the period when the commissions were paid). Wages to employees are reported as an expense in the week when the employees worked and not in the week when the employees are paid. If a company agrees to give its employees 1% of its 2012 revenues as a bonus on January 15, 2013, the company should report the bonus as an expense in 2012 and the amount unpaid at December 31, 2012 as a liability. (The expense is occurring as the sales are occurring.) Because we cannot measure the future economic benefit of things such as advertisements (and thereby we cannot match the ad expense with related future revenues), the accountant charges the ad amount to expense in the
period that the ad is run. (To learn more about adjusting entries go to Explanation of Adjusting Entriesand Drills for Adjusting Entries.)
Under the accrual basis of accounting (as opposed to the cash basis of accounting), revenues are recognized as soon as a product has been sold or a service has been performed, regardless of when the money is actually received. Under this basic accounting principle, a company could earn and report $20,000 of revenue in its first month of operation but receive $0 in actual cash in that month. For example, if ABC Consulting completes its service at an agreed price of $1,000, ABC should recognize $1,000 of revenue as soon as its work is doneit does not matter whether the client pays the $1,000 immediately or in 30 days. Do not confuse revenue with a cash receipt.
9. Materiality
Because of this basic accounting principle or guideline, an accountant might be allowed to violate another accounting principle if an amount is insignificant. Professional judgement is needed to decide whether an amount is insignificant or immaterial. An example of an obviously immaterial item is the purchase of a $150 printer by a highly profitable multi-million dollar company. Because the printer will be used for five years, the matching principle directs the accountant to expense the cost over the five-year period. The materiality guideline allows this company to violate the matching principle and to expense the entire cost of $150 in the year it is purchased. The justification is that no one would consider it misleading if $150 is expensed in the first year instead of $30 being expensed in each of the five years that it is used. Because of materiality, financial statements usually show amounts rounded to the nearest dollar, to the nearest thousand, or to the nearest million dollars depending on the size of the company.
10. Conservatism
If a situation arises where there are two acceptable alternatives for reporting an item, conservatism directs the accountant to choose the alternative that will result in less net income and/or less asset amount. Conservatism helps the accountant to "break a tie." It does not direct accountants to be conservative. Accountants are expected to be unbiased and objective. The basic accounting principle of conservatism leads accountants to anticipate or disclose losses, but it does not allow a similar action for gains. For example,potential losses from lawsuits will be reported on the financial statements or in the notes, but potential gains will not be reported. Also, an accountant may write inventory down to an amount that is lower than the
original cost, but will not write inventory up to an amount higher than the original cost.
AS 19 Leases AS 20 Earnings Per Share AS 21 Consolidated Financial Statements AS 22 Accounting for Taxes on Income. AS 23 Accounting for Investments in Associates in Consolidated Financial Statements AS 24 Discontinuing Operations AS 25 Interim Financial Reporting AS 26 Intangible Assets AS 27 Financial Reporting of Interests in Joint Ventures AS 28 Impairment of Assets AS 29 Provisions,Contingent` Liabilities and Contingent Assets
AS 30 Financial Instruments: Recognition and Measurement and Limited Revisions to AS 2, AS 11 revised 2003), AS 21, AS 23, AS 26, AS 27, AS 28 and AS 29 AS 31, Financial Instruments: Presentation Accounting Standard (AS) 32, Financial Instruments: Disclosures, and limited revision to Accounting Standard (AS) 19, Leases
Accepting additional business. Making or buying parts or products. Selling products or processing them further. Eliminating a segment.
What is Inventory? Inventory is defined as assets that are intended for sale, are in process of being produced for sale or are to be used in producing goods. The following equation expresses how a company's inventory is determined: Beginning Inventory + Net Purchases - Cost of Goods Sold (COGS) = Ending Inventory In other words, you take what the company has in the beginning, add what it has purchased, subtract what's been sold, and the result is what remains.
First-In, First-Out (FIFO) This method assumes that the first unit making its way into inventory is the first sold. For example, let's say that a bakery produces 200 loaves of bread on Monday at a cost of $1 each, and 200 more on Tuesday at $1.25 each. FIFO states that if the bakery sold 200 loaves on Wednesday, the COGS is $1 per loaf (recorded on the income statement) because that was the cost of each of the first loaves in inventory. The $1.25 loaves would be allocated to ending inventory (appears on the balance sheet). Last-In, First-Out (LIFO) This method assumes that the last unit making its way into inventory is sold first. The older inventory, therefore, is left over at the end of the accounting period. For the 200 loaves sold on Wednesday, the same bakery would assign $1.25 per loaf to COGS, while the remaining $1 loaves would be used to calculate the value of inventory at the end of the period. Average Cost This method is quite straightforward; it takes the weighted average of all units available for sale during the accounting period and then uses that average cost to determine the value of COGS and ending inventory. In our bakery example, the average cost for inventory would be $1.125 per unit, calculated as [(200 x $1) + (200 x $1.25)]/400.