Accrual Principle of Accounting: Definition

The accrual principle is often confused with—or treated as only an aspect of—the matching principle.

This principle, in fact, relates to expenses that are not specifically related to the source of revenue, but which are incurred by the business for its existence or general conduct.

Accrual Principle of Accounting: Explanation

The accrual principle states:

If an expense has been incurred in a particular accounting period (i.e., if the benefit against it has been received), it should be included as an expense in the period’s income statement, whether or not it has been paid for.

To illustrate, consider an example: when a business sells any goods, the cost of the specific goods must be matched—this is part of the matching principle.

In addition to the purchase of these goods, the business also incurs certain other expenses that are not specifically related to these goods, such as telephone expenses.

Since the income statement is based on a specific accounting period, the cost of all phone calls made in that period must be classified as an expense for the same period, even if the telephone bill is received and paid for in the next accounting period.

The crucial point to remember is this: the test is the time when the service or benefit against the expense is received, not when it is paid for.

Example

Let’s consider an extreme example and assume that a business records no sales in a particular month.

The business will, therefore, have no revenue for that month and no direct costs. However, certain expenses will still be incurred in that month that are not directly related to sales (e.g., rent).

Some of these indirect expenses may not have been paid by the end of that month, despite being accrued in that period.

The accrual principle states that an expense should be booked when it has taken place regardless of whether it has been paid or not, and regardless of its direct or indirect relationship to revenue.

Similarly, if an income is time-related and that time has passed (e.g., interest on a bank deposit), it should be recorded in the accounts even if it hasn’t been received in the corresponding accounting period.

Frequently Asked Questions

Why is the principle called “accrual”?

The term “accrual” derives from the fact that expenses are recognized in an accounting period other than when they are paid—when they have accrued.

Why do I need to follow the accrual principle?

Accounting standards require that revenues and expenses should be recognized when they have been earned or incurred.

On what basis will you compute indirect expenses?

You will compute indirect expenses by applying the ratio of indirect over direct labor hours.

Do I need to record my income before it’s received?

Yes, you should book your income even if it has not been received in cash or check form.

What is the effect of not applying the accrual principle?

The effect would be that you incur some expenses but fail to record them. This will lead to wrong calculation of earnings, which is very important for tax purposes.

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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