Accrual Concept of Accounting: Definition

The accrual concept of accounting is based on the economic premise that profits are best measured by changes in owners’ equity between the beginning and the end of any accounting period.

Accrual Concept of Accounting: Explanation

According to the accounting equivalence concept, when sales of goods or services are made, assets are likely to go up, either by way of cash or accounts receivables.

But it cannot be said that the claim of an outsider (i.e. liabilities) will increase because of such an increase in assets. Accordingly, revenues are accounted for as increases in owners’ equity.

However, to generate sales, a business enterprise has to incur expenses. In such cases, the assets will decrease, and here again, it cannot be said that outsiders will accept their original claims at lower value due to the decrease in assets.

It follows that all expenses are accounted for as reductions in owners’ equity. Since the differences between sales or revenues and expenses represent profit, owners’ equity will show an increase if profits are earned (or a decrease if losses are incurred).

In this context, a distinction has to be drawn between income and earnings. Income is properly conceptualized as profit earned and reflected by a net increase in owners’ equity.

It is, therefore, wrong in the accounting sense to label sales as “income” because such an accounting treatment does not take into account the expenses to be incurred before the sales revenue is properly adjusted to income for the period.

Earnings or revenues, then, are those transactions that lead to a gross increase in owners’ equity on account of goods transferred or services rendered to customers.

It is, however, necessary to note that there is no certainty that “income” will automatically be generated if sales are made.

This will be the case only if expenses incurred to generate revenues during the current accounting period are less than revenues earned during the period. Receipts either by way of cash or other assets merely represent the settling of a claim.

They are not in any way synonymous with either income or earnings without a proper accounting of revenues earned during the current accounting period and deduction of expenses incurred during the period for earning such revenues.

Contrary to popular belief, a large holding of cash does not necessarily mean that the business enterprise is profitable. It merely means that it is able to collect claims quickly.

There is no certainty that the original sale, out of which such cash receipts arose, was necessarily made on a basis that resulted in the generation of economic surpluses.

Similarly, there is no reason to believe that because a business enterprise is short of cash, it is unprofitable.

In fact, it is not at all unusual to find that a business with large profits, but which has also identified many areas for profitable investments, is short of cash.

Frequently Asked Questions

Has the cash basis of accounting been replaced by the accrual concept?

No. The accrual and cash basis of accounting can both be used side-by-side as both systems have their own relevance and applicability.

Are capital expenditures treated as expenses?

Capital Expenditures are-treated as assets, and they do not form a part of the expenses. They are, thus, taken to retain their value and location in the Balance Sheet.

What does “bottom line” refer to?

The “bottom line” refers to the last figure in the statement of financial position or any profit and loss A/C. Thus, the “bottom line” of a profit and loss A/C is either a net profit or a net loss.

What is the distinction between income and earnings?

Income refers to the difference between sales or revenues and expenses for a period. It is, thus, the correct equivalent of economic progress. Earnings, on the other hand, are those transactions that lead to a gross increase in owners’ equity on account of goods transferred or services rendered to customers.

What are cash receipts?

Cash receipts are merely the settlement of claims. They must not be confused with either income or earnings without proper accounting.

True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

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