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Accrual Concept
The accrual concept is one of the three fundamental accounting assumption. As per accrual concept, transaction and events are recorded on mercantile basis i.e. as and when they arise rather than on cash basis.
Accrual implies recognition of revenue and expenses as they are earned or incurred and not when they are received or paid. It clarifies the difference between receipt of cash and write to receive it and disbursement of cash and obligation to disburse it.
Need for accrual concept:
A business entity regularly undertakes credit transactions like selling or buying goods on credit, receiving services without making payments at that point of time etc. if companies receive the cash payment for all revenues at the same time when they are earned and made cash payment for all expenses at the same time when they are incurred, there would not be a need for accrual basis. However, in the business world there is a need to enter into transactions on credit basis, accrual concept is very important while accounting for revenue and expenses. Thus accrual basis gives a more realistic idea of income and expenses during a period of time, therefore providing for a long-term picture of the business which cash basis cannot provide.
Cash basis v/s. Accrual basis:
Practical example:
Let’s create a situation in which you are the owner of business which trades in thread. In April, you purchased 1,000 boxes of thread at Rs.45 per box. You sold all the boxes in April for Rs.50,000 and sent bills to the customers. At the end of the month, customers paid Rs.30,000 and you have paid 45,000 to your suppliers.
Now, if the business entity follows cash basis of accounting, the profit and loss account will show sales revenue of Rs.30,000 for the month of April and purchase expenses of Rs.45,000 for the month which results in a loss of Rs.15,000 for the month of April. If the balance amount of Rs.20,000 is received from customers in the month of May, profit for the month of May as per cash basis will be Rs.20,000 without even selling a single roll of thread.
But if the entity follows accrual basis of accounting, the profit and loss account will show sales revenue of Rs.50,000 as against expenses of Rs.45,000 resulting in a profit of Rs.5000 for the month of April.
However, while using accrual basis of accounting it must be kept in mind that if the amount due from customer Rs.20,000 or part thereof could not be received in future then the profit of Rs.5000 shown in the month of April will go wrong.
Provision of Companies Act & Income Tax Act:
As per section 128 & 129 of Companies Act, the books of accounts and financial statements of company shall be prepared following the accrual basis of accounting.
As per Income tax act 1961, while computing income under the head PGBP & Other sources, the assessee shall follow cash or accrual basis of accounting as regularly employed by it.
Limitations of Accrual Basis:
The drawback of accrual basis of accounting is that a firm might end up paying higher taxes or distributing higher dividends even when it might not have received the income. This accounting system leads to creation of different provisions which requires management judgement as there is always uncertainty in actual receipt. The judgements are made on mere assumptions which may turn wrong and in turn reduces the reliability of financial statements.
Contribution and Credits:
- Introduction - Ayush Rathi (CA Inter Nov 20 batch)
- Need - Radhika Chandak (CA Inter Nov 20 batch)
- Cash basis v/s Accrual basis - Harshit Sarda (CA Inter Nov 20)
- Example - Hemant Kothari (CA Inter Nov 19 batch)
- Limitations - Charu Sancheti (CA Inter Nov 20 batch)
