Accrual Concept of Accounting
What does the accrual concept of accounting mean? – Definition
The accrual concept of accounting is based on the economic premise that profits are best measured by changes in owner’s equity between the beginning and the end of any accounting period.
As we know in relation 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 any outsider (i.e. liabilities) will increase because of such an increase in assets. Accordingly, revenues are accounted for as increases in owners’ equity.
However, we know that in order to affect 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. So 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 conceived 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 required t? be incurred, before the sales revenue is properly adjusted to income for the period.
Earnings or revenues, then, are those transactions which 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 for earning 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, were necessarily made on a basis which resulted in the generation of economic surpluses. Conversely, 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 which has earned large profits, but has also identified many areas of the profitable investment may be short of cash.