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Accrual: Generally Accepted Accounting Principles and Revenue

Accrual concept Accrual Concept is a fall-out of Accounting Period concept. This concept requires that expenses incurred for a particular accounting period should be reckoned in the same period, irrespective of the fact whether these expenses have been paid in cash or not in that year. The same holds true for revenues, i. e. , revenues earned in a specific accounting period are construed as incomes of the same period, irrespective of their receipts. This concept is also known as the accrual theory of accounting or accrual accounting. This concept applies equally to revenues and expenses.

In the accrual basis of accounting Revenue is recognized when it is realized, that is, when the sale is complete or not. Similarly, the expenses are recognized in the accounting period in which they assist in earning the Revenues, whether the cash has been paid for them or not. Recognition of revenues and expenses for the income determination, therefore, does not depend upon the time when the cash is actually received for expenses or paid for expenses. The essence of revenue is that a mere promise on the part of a customer to pay the money for the sale or service or Interest, Commission, Rent etc. in future is considered as Revenue.

Similarly, a promise on the part of the business entity to make payment for salaries, rent etc. ion future is considered as an Expense. Income (excess of Revenue or Expenses) is associated with the change in the owners’ equity and that is not necessarily related to changes in cash. Example A business entity may sell goods for $20000 on December 25, 2004 and the payment is not received until January 25, 2005. The sale of goods would result in an increase in the assets (debtors) of the firm of $20000 and increase in the capital by the same amount (of course to be reduced by the cost of the goods sold) although no cash has been received.

However, when the Cash is received on January 25, 2005, this would not result in Revenue. It would result in increase in one asset (cash) and a decrease in another asset (debtors). Similarly expenses and cash payments are not the same because a distinction is made between Capital and Revenue Expenditures. Other Examples of Cash Payments which are not expenses include purchase of a machine for cash (an increase in one asset – machine and a decrease in the other asset – cash), the payment of creditors and so on.

Thus, we can say that the accrual concept makes the distinction between the receipts of cash and the right to receive the cash and the payment of cash and legal obligations to receive cash, because in practice there is usually no coincide3nce in time between cash movements and legal obligations which they relate. The justification for the accrual concept is that earning of revenue and consumption of a resource (expenses) can be accurately related to particular or specific accounting period. This would enable the measurement of Income of matching expenses and revenue. The drawbacks include:- i.

The apportion of expenses to different time periods is a time consuming process and      ii. Financial statements become more complex for the layman who may find it difficult to understand the difference between the actual receipt of cash and the right to receive the cash and also the actual payments and the obligation to pay. In other words the inclusion of prepayments and inclusions in the Balance Sheet may not be understood easily In the absence of Accrual accounting, the Income Statement may indicate more profit in one year at the cost of the profits of some other year, which is entirely inappropriate and illogical.

In other words, cash basis of expense recognition will hamper comparison of profit figures over the years. Clearly, there is a very strong case for a business firm to adopt accrual basis of accounting, known as Accrual accounting to determine correct profits. What holds true for expenses, the same holds true for revenues. Revenues are recognised at the time of sales and not at the time of receipts from debtors. In operational terms, cash surplus and deficiency are not indicative of profit and loss situations respectively. Realization Concept

Revenues are recognized when goods and services are delivered and in an amount that is reasonably certain to be realized”  There are two important dimensions to this principle, i. e. when revenue is recognized, and whether it is certain that all revenue will eventually be collected. If the accountant believes that based on past experience only 90% of revenues will be collected, then the accountant will create an “allowance for doubtful accounts”. The income or the profit of a business is defined as “The increase in Net Assets measured by excess of Revenues over Expenses. ” The term Net Assets means excess of Assets over Liabilities.

Revenues result from the sale of goods and services and include gains from the sale and exchange of assets other than inventories, interest and dividends earned on Investments and other increases in owners’ equity during a period other than capital contribution and adjustments. A major problem in the determination or measurement of Income is related to the point at which the revenue is recognized. It is possible to recognize the revenue at different points in the production/selling levels. Example: * When cash is received from the customer * When an order is received from a customer * When the goods are produced When the goods are delivered to a customer and accepted by him It must be clearly borne in mind that a particular point chosen would have a significant effect on the total revenues of a given accounting period. Realization concept in Accounting is formulated to solve the problem of revenue recognition. This concept states that the revenue should be recognized only when it has been realized. The essential meaning of Realization is that revenue or the liability should not be recognized in the books of accounts unless a change in the asset or liability has become sufficiently definite and objective for recognition in the books of account.

Thus realization means as to when a transaction gives a legal right to the receipt of money. The essence of realization concept, then certainly is the timing of the revenue recognition, that is, when the revenue becomes the revenue of the business enterprise. hide Prudence concept Accounting concept that requires recording (recognizing) the expenses and liabilities as soon as possible, but the revenues only when they are realized or assured. It implies that only that method of determining asset value or net income which yields the lesser amount should be used. See also accounting concepts.

The prudence concept in accounting governs the recording and reporting of financial transactions, “such that the assets or income are not overstated and liabilities or expenses understated” (BPP Learning Media Ltd. , ACCA Study Text). Prudence in accounting is about exercising due caution in preparing financial statements to reflect the least favourable position, particularly as accounting depends on estimates-even for simpler transactions. It is, therefore, one of the fundamental principles of financial accounting and is considered very important by the IAS 1 (International Accounting Standard).

Often, in accounting, there are a body of methods that can be used for valuation. The different methods of estimating depreciation are a prime example. The principle of prudence holds that, where there are alternative methods or valuations, you should apply the one with the most conservative result. In deciding the value of stock for example, it would be prudent to use the cost price of the stock as opposed to the selling price. This is because the sale of that stock is merely anticipated. The derived principle from this is that where revenue is anticipated, the valuation should be conservative or cautious.

On the other hand, there are anticipated expenses and liabilities. Anticipated expenses and liabilities are treated differently under the prudence concept. They are immediately recorded or taken into account, even if the loss has not yet been experienced. An example of this concept in an everyday situation, is if you foresee that you have to make your mortgage payment at the end of the month. When you budget at the start of the month, you should anticipate that expense before it is due. When the expense is due, you would likely be in a position to cover it.

Businesses ought to address devalued stock and debt servicing in the same way. The principle of prudence also governs the handling of profit. Even though a business can expect profit, it must not be recorded before it is realized. One reason for this is that any number of factors can affect the business’ profits positively or negatively. Ideally, profit should be in cash form, because of the ease of determining the value of cash. In addition, the cash value of profit from assets must be certain-within reason. An example of this is if you sell an asset and use the proceeds to buy a higher-value asset.

You can only declare a profit once you purchase the higher-value asset and once it maintains a determinable value by the end of the financial period. The prudence concept creates a proper platform for accounting standards and reinforces the fundamentals of financial reporting-such as the principle of Fair Presentation, which dictates that financial reports should fairly reflect the financial position and cash flows of an organisation. In addition, the prudence concept is not meant to justify withholding revenue or creating covert reserves, since this is not in keeping with the principle of Fair Presentation.

Financial accounting is premised in fundamental assumptions. Prudence is one of these, although it is not in the four fundamental assumptions stated in IAS 1. You can read about two of the four fundamental assumptions of financial accounting (consistency of presentation and accruals) below: | | Materiality concept The Materiality concept is the principle that trivial matters are to be disregarded in accounting, and all important matters are to be disclosed. Items that are large enough to matter are material items. The materiality concept is an established, recognized accounting convention.

Another such convention is the historical cost convention, by which transactions are recorded at the price prevailing when the transaction is made, and assets are valued at original cost. Comparing the two conventions, however, historical costs are usually ascertained and agreed rather objectively, with little uncertainty, whereas applying the materiality concept may call for more subjective judgment. Moreover, the subjective judgments of senior management, accountants, auditors, boards of directors, stockholders, and potential business partners, can differ, especially when competing interests are injvolved.

Why is the materiality concept important and necessary in financial accounting? Note that some of the reasons explained below also show that materiality is necessary and inevitable in business case analysis, as well. Materiality depends on the size and nature of the omission or misstatement judged in the surrounding circumstances. The size or nature of the item, or a combination of both, could be the determining factor. The materiality concept addresses omissions and misstatements in accounting reports and in business case analysis.

Some omissions are inevitable and desirable in both cases. * An income statement, for instance, is meant to help stockholders, management, and boards of directors make judgments—judgments about investing, managing, and evaluating management performance. A statement referring to every item in the general ledger would difficult to prepare and even more difficult to read and use. * Similarly, a business case analysis is a tool for decision support and planning. Non material details are simply distracting and pointless.

On the other hand, omission or misstatement of material items would work against the purpose in either case. The predominant approach to deciding what is material and what is not, is the view taken by GAAP (Generally Accepted Accounting principles) that items are material if they could individually or collectively influence the economic decisions of users, taken on the basis of financial statements. This definition is consistent with a more formal statement from the United States Financial Accounting Standards Board (FASB). Materiality refers to … the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement. CONSISTENCY CONCEPT Once a business has adopted on one accounting method, it should use the same method for all subsequent events of the same character unless it has sound reason to change. This concept advocates that there must be consistent treatment for similar items within each accounting period and from one period to the next.

Example Company A has received annual rebates from its supplier approximately to $1 million. Every year, it is the company’s accounting policy to net these rebates against the purchases from the suppliers. But for this year, this is taken up as income. Question: Is this correct ? Answer: Under the consistency concept, this is not correct as every year the Company A has been taking these rebates against the purchases but all of a sudden, it changes its accounting policy by taking up as revenue. References www. allbusiness. om/accounting-reporting/… /1308-1. html www. bizresearchpapers. com/Saleh. pdf accountinginfo. com/study/accrual-101. htm – www. prlog. org/my/cat-accounting www. fso. arizona. edu/training/tutorials/accounting/ www. wannalearn. com/Business_and_Careers/Accounting/ www. tutorialized. com/tutorials/Accounting/1 www. quickmba. com/accounting/ – www. financial-dictionary. thefreedictionary. com/Accrual+Accounting http://www. helium. com/items/1714234-consistency-concept-in-accounting http://www. helium. com/items/1713540-accruals

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