2018-08-08 20:39:07Finance and Accounting: Finance and AccountingEnglishAccrual accounting measures performance & position of a company by recognizing the economic events regardless of when cash is received.https://quickbooks.intuit.com/in/resources/in_qrc/uploads/2018/08/A-document-showcasing-accrual-accounting.jpghttps://quickbooks.intuit.com/in/resources/finance-and-accounting-finance-and-accounting/accrual-accounting-2/What is Accrual Accounting? – Meaning & Application

What is Accrual Accounting? – Meaning & Application

17 min read

“Transformative measures have to be undertaken to make Indian Railways competitive to retain its position of pre-eminence. As part of accounting reforms, accrual based financial statements will be rolled out by March 2019.” – Arun Jaitley, 2017 Budget Speech

The Finance Minister, Mr Arun Jaitley, in his 2017 budget speech proposed to make Indian railways competitive and transparent. One of the initiatives was regarding the accounting reforms for Indian Railways. He stated that as part of bookkeeping reforms, Indian Railways need to establish accrual-based accounting system by March 2019. Well, such a transition is a major step towards initiating accounting reforms for the Indian Railways since independence.

The roots of such a reform date back to the pilot study on “introduction of accrual accounting” conducted by Indian Railways. This study was conducted in collaboration with Institute of Chartered Accountants of India (ICAI) in December 2016. The ICAI studied in detail the existing accounting system of the Indian Railways. Eventually, they worked out a detailed procedure to convert the present cash based system into accrual based accounting system for the Indian Railways.

But Why Ministry Of Railways Decided To Supplement The Existing Cash Based Accounting With Accrual Based Accounting System?

The Ministry of Railways (MOR) undertook the decision to prepare its financial statements on accrual based accounting system for a variety of reasons. Firstly, such an accounting system would lead to better understanding of financial information in India and globally. This is because accrual accounting gives a more accurate picture of a company’s financial position. Secondly, there will be optimal utilization of public funds as a result of better control and monitoring over resources. And lastly, such a system will command right pricing as a result of determination of full cost of provision of services.

This brings us to the basic queries including:

  • What is Accrual Accounting?
  • How is it different from Cash Based Accounting?
  • Why is it preferred over Cash Based Accounting?

I. What Is Accrual Accounting?

Definition

Accrual accounting is an accounting method that measures the performance and position of your company by recognizing the economic events. This is regardless of when the cash transactions occur in your business. By recognizing, we mean recording of a transaction.

The underlying concept in accrual accounting emphasizes that the revenues of your business are recognized when they are earned. This brings in the matching concept of accounting. Accordingly, the economic events of your business are recognized by matching the costs incurred with the revenues earned at the time when a transaction occurs. It is regardless of whether cash has been paid or not.

In this way, revenues are matched with expenses. And the net income or net loss of your business is determined. This is unlike the cash based system where transactions are recognized when the cash is paid out or received.

Example

Say for instance, you own a construction company. And currently, your company is engaged in building a business complex. During the development stage, your company would have to pay for raw materials, wages, insurance and other expenditure related with the construction. At the same time, your business would not receive cash until the portions of the development are sold. In such a scenario, if your business would have been practicing cash based accounting system, the income statement would have reflected losses. This would have been quite misleading as such a system would not provide a realistic picture of your business.

How Is Accrual Accounting Different From Cash Accounting?

The system of accrual accounting gives a more accurate picture of your company’s current financial condition. It avoids misleading income statement results that may occur from the timing of cash receipts and payments. The accrual system allows the current cash flows (inflows/outflows) to be combined with future expected cash inflows/outflows.

Additionally, this system requires your business to maintain complete record of assets and liabilities. Plus, it provides a uniform framework for identifying and recording existing liabilities, and potential or contingent liabilities.

II. Application of Accrual Basis of Accounting

To illustrate the accrual basis of accounting system, let’s consider the following transactions of Ashiana Healthcare in November 2017:

1. November 1, 2017

The Healthcare received INR1,800 from Verma Packers. The amount was against rent paid by Verma Packers for using Ashiana Healthcare’s Land from November 2017 through March 2018.

Effect on Balance Sheet

Since rent is received in advance, Ashiana Healthcare should record this transaction as unearned revenue. This will increase cash by INR 1,800. Also, an equal amount of liability would increase in the name of unearned revenue.

2. November 1, 2017

Ashiana Healthcare paid INR 2,400 towards 2 year general business insurance policy premium.

Effect on Balance Sheet

The purchase of general business policy is treated as an asset. This is because by paying the premium in cash, Ashiana Healthcare gets insurance coverage against fire, theft etc. Therefore, cash reduces by INR 2,400. Also, an asset in the name of prepaid expense increases by INR 2,400.

3. November 1, 2017

Ashiana paid INR 6,000 towards premium for a 6 month medical policy.

Effect on Balance Sheet

This transaction is similar to the one in point 2. The only difference lies in the term of renewal for the medical policy. That is, it gets renewed after every 2 years. Thus, the cash reduces by INR 6,000 and an asset in the name of Prepaid Expense increases by INR 6,000.

4. November 2, 2017

Dr. Sharma invested INR 5,000 in Ashiana Healthcare in exchange for capital stock.

Effect on Balance Sheet

The cash increases by INR 5,000. And the capital stock also increases by an equal amount.

5. November 4, 2017

Ashiana Healthcare bought supplies worth INR 240 for which cash has not been paid.

Effect on Balance Sheet

Since the supplies are used in generating revenue, they are assets for the business. This is despite the fact that cash has not been paid for such supplies. Therefore, an asset in the name of supplies increases by INR 240. And a liability of accounts payable also increases by the same amount.

6. November 5, 2017

Ashiana Healthcare paid INR 8,500 against office equipment. INR 1,700 was given in down payment. For the balance amount, five monthly installments of INR 1,360 each would be given starting December 1, 2017.

Effect on Balance Sheet

In this transaction, office equipment on the asset side increases by INR 8,500. And since only INR 1,700 is paid in cash, therefore the cash reduces by INR 1,700 only. The balance amount of INR 6,800 increases the notes payable on the liability side of the balance sheet.

7. November 8, 2017

The Healthcare provided services worth INR 6,100 to the patients. The cash for the services rendered has not been received.

Effect on Balance Sheet

In the above transaction, cash worth INR 6,100 has not been collected for the services rendered to the patients. Such an amount would be treated as accounts receivable. This increases the accounts receivable on the asset side by INR 6,100. And an equal amount of retained earnings increase on the liability side.

8. November 9, 2017

Ashiana Healthcare received INR 5,500 for services provided to the patients. The payment was received in cash.

Effect on Balance Sheet

Since the patients pay in cash, the cash on the asset side increases by INR 5,500. Also, an equal amount of retained earnings increase on the liability side of the balance sheet.

9. November 12, 2017

Ashiana received cash of INR 4,200 from insurance companies. This amount was provided by the insurance companies on the accounts of patients to whom services were rendered.

Effect on Balance Sheet

In this transaction, cash increases by INR 4,200 on the asset side. It is to be noted that the amount paid by insurance companies is on the accounts of patients to whom services have been given by the Healthcare. Therefore, with the receipt of such amount, the accounts receivable reduces by INR 4,200.

10. November 13, 2017

The Healthcare paid cash worth INR 100 for supplies purchased earlier.

Effect on Balance Sheet

With this transaction, both cash and accounts receivable get reduced by INR 100.

11. November 17, 2017

Following were the expenses incurred in the month of November, 2017 by Ashiana Healthcare:

(1) Wages INR 2,790; (2) Rent INR 800; (3) Utilities INR 580; (4) Interest INR 100; (5) Miscellaneous INR 420.

Effect on Balance Sheet

Since all the expenses are incurred in cash, this reduces cash by INR 4,690 on the asset side. Also, the retained earnings on the liability side get reduced by an equal amount.

12. November 21, 2017

Ashiana Healthcare paid dividends worth INR 1,200 to the shareholders, including Dr Sharma.

Effect on Balance Sheet

In this transaction, the cash reduces by INR 1,200. And the payment of dividends reduces the retained earnings by INR 1,200.

III. Adjustment Process

The method of accrual financial accounting requires updating of your accounting records before the preparation of financial statements. The process of updating is known as adjustment process. It plays an important role in matching your business’ revenues and expenses properly.

These adjustments are mandatory. This is because there might be some components in your business’ financial statements that are not up to date. Let’s consider prepaid insurance and supplies mentioned in Ashiana Healthcare’s November 2017 transactions. Over a period of time, both prepaid insurance will expire and supplies will be utilized in business operations. So, it is not practical to record day-to-day expiration of prepaid insurance or utilization of supplies. Therefore, in accrual accounting, your accounting records need to be updated for such elements before preparing financial statements.

Types of Adjustment

There are 2 types of adjustments that impact your financial statements:

  • Deferrals
  • Accruals

Deferrals

In accounting, a Deferral refers to delaying the recognition of certain revenues or expenses on your income statement until a later date. Because the revenues or expenses are prepaid, these are not recognized immediately on your income statement.

Deferral Expenses

Deferred expense is reported as an asset on your balance sheet under Prepaid Expense account. Such an asset is expected to become an expense over the course of your business operations. In case of Ashiana Healthcare, prepaid insurance is an example of deferral expense that will be recognized over a period of time.

Deferred Revenues

Similarly, the deferred revenues are reported as liability on your balance sheet under Unearned Revenue account. Such a liability is expected to turn into revenue over the course of your business operations. In case of Ashiana Healthcare, unearned rent is an example of deferral revenue that will be recognized over a period of time.

Accruals

Under accrual based accounting, accruals refer to the expenses or revenues that have been incurred or earned but not recorded in the books of accounts. Such revenues are earned or expenses are incurred before any cash is received or paid. Therefore, adjustments need to made in the financial statements to report these at the end of the accounting period. For example, employee wages are earned before the end of the month. But these are paid to the employees after the month ends.

Accrued Expenses

Accrued expenses (or accrued liabilities) are the expenses that have been incurred but have not been recorded in the books of accounts. In case of Ashiana Healthcare, interest on notes payable is an example of accrued expense. Other examples include utility expenses and taxes.

Accrued Revenues

Accrued revenues (or accrued assets) are the revenues that have been earned but have not been recorded in the books of accounts. Few of the examples of accrued revenues include:

  • Interest accrued on bills receivable
  • Accrued rent on property
  • Fees charged by an attorney for the services rendered

IV. Adjustments for Ashiana Healthcare

Following adjustments are to be incorporated into the financial statements of Ashiana Healthcare by the end of November 2017:

Deferred Expenses

  • Expiration of prepaid insurance worth INR 1,100.
  • Utilization of office supplies worth INR 150.
  • Depreciation on office equipment worth INR 160.

Deferred Revenue

  • Unearned revenue worth INR 360 earned by the end of November.

Accrued Expenses

Wages worth INR 220 owed to employees but not paid to them.

Accrued Revenue

Services worth INR 750 provided to the employees but not billed to insurance companies.

Adjustment #1 (Prepaid Insurance under Deferred Expense)

Ashiana Healthcare had 2 insurance policies.The 2 year general business policy expired at the rate of INR 100 (2400/24) per month. Whereas, the medical policy extinguished at the rate of INR 1,000 (6000/6) per month. The total prepaid insurance extinguished during the of November 2017 amounted to INR 1,100. Therefore, prepaid insurance on the asset side reduces by INR 1,100. And retained earnings of an equal amount also get reduced on the liability side of the balance sheet.

Adjustment #2 (Utilization of Supplies under Deferred Expenses)

Ashiana Healthcare had purchased office supplies worth INR 240 for which payment was yet to be made. Supplies worth INR 150 were utilized in the month of November 2017. And the left over supplies worth INR 90 were to be utilized in the months to come. Therefore, office supplies on the asset side reduced by INR 150, thereby leaving balance supplies of INR 90. And retained earnings worth INR 150 also reduced on the liability side of the balance sheet.

Adjustment #3 (Depreciation under Deferred Expense)

Ashiana Healthcare uses fixed assets such as office equipment. These assets lose their ability to provide service over time due to wear and tear. To capture such a loss, the amount of fixed asset that becomes the wear and tear expense over the asset’s useful life is estimated. This wear and tear expense is nothing but the depreciation. Thus, depreciation worth INR 160 is deducted from the accumulated depreciation account on the asset side. And the retained earnings on the liability side of the balance sheet are also reduced by an equal amount.

Adjustment #4 (Unearned Rent under Deferred Revenue)

Out of the total five month rent received from Verma Packers, Ashiana Healthcare earned INR 360 (1800/5) worth rent for the month of November 2017. Therefore, the unearned revenue on the liability side reduces by INR 360. And retained earnings on the liability side increase by an equal amount.

Adjustment #5 (Wages under Accrued Expense)

At the end of November, 2017, employees of Ashiana Healthcare worked for few additional days. And for that, they did not receive the wages. Therefore, the accrued wages increased by INR 220 on the liability side of the balance sheet. Also, the retained earnings on the liability side are reduced by an equal amount.

Adjustment #6 (Fees Earned under Accrued Revenue)

Ashiana Healthcare provided services to patients that were not billed. Therefore, the accounts receivable on the asset side increases by INR 750. And the retained earnings on the liability side of the balance sheet also reduces by an equal amount.

Following is the summary of transactions for Ashiana Healthcare for the month of November 2017:

V. Accrual Basis Financial Statements

This section illustrates the financial statements of Ashiana Healthcare for the month of November 2017. These statements are prepared on the basis of accrual accounting. Here, the income statement of Ashiana Healthcare is prepared by compiling the revenue and expense transactions under its retained earnings.

The operating income is evaluated by subtracting operating expenses from the income earned by Ashiana from its regular business activities. Then, other income including income from giving Ashiana land on rent is then added to operating income. This gives net income for the month of November.

As showcased in the income statement of Ashiana Healthcare, revenues are nothing but net increase in stockholders equity. Such an increase results from selling products or providing services to the customers. Also, the operating income is stated separately from the other income in the income statement.

On the other hand, the expenses on the income statement are the assets utilized or services consumed in order to generate revenues. Under accrual accounting, these expenses are matched with their corresponding revenues to calculate net income for a given period.

VI. Why Accrual Basis Is Preferred Over Cash Basis

The financial statements of Ashiana Healthcare showcase that there are major differences between cash basis and accrual basis of accounting. The net income for Ashiana Healthcare in the month of November 2017 stood at INR 6,390. While, the net cash flow from operations reported a negative balance of INR 1,690. This was so because Ashiana Healthcare used accrual basis of accounting to report transactions in financial statements.

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However, if the Healthcare unit would have been following cash basis of accounting, the net income and cash flow from operations would be the same. That is a negative amount of INR 1,690. Such a result would have let the Healthcare unit conclude that it was not doing well.

But if we look at the results reported under accrual based accounting, the scenario is a bit different. Under accrual based accounting, Ashiana Healthcare reported a net income of INR 6,390. This illustrates that the unit is profitable and has been expanding business rapidly.

Also, the accrual basis of accounting emphasizes on preparing cash flow statement. This is because cash flows are an important measure in determining how far your revenues get turned into cash. If cash flow from operations is higher than your business’ net income constantly, it means net income is of high quality. However, if cash from operations is less than the net income consistently, there are chances of your business getting bankrupt.

Information may be abridged and therefore incomplete. This document/information does not constitute, and should not be considered a substitute for, legal or financial advice. Each financial situation is different, the advice provided is intended to be general. Please contact your financial or legal advisors for information specific to your situation.

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