The accruals concept is one of the fundamental accounting concepts which – more or less – dictates how we do accounting. I have written about the accruals concept previously. Briefly, the accruals concept means that revenues and costs need to be matched against each other – when something is paid, or when the cash is received is not relevant.
Here is a great real life example. As you may know, Microsoft released Windows 8 in October 2012. Of course, for Windows 8 to be available on new devices, Microsoft sold it to equipment manufacturers well in advance of this. This means they had incurred the cost of distributing the software to the manufacturers and also received payment. However, the cash received is not a sale in accounting terms as the software was not officially released until October 26th, 2012. Or, to put this in accruals concept terms, there could be no matching of costs and revenues until the actual official release date had passed. So, in their quarterly report at the end of September 2012, Microsoft deferred revenues of $783 million. You can read more here.
The prudence concept is another fundamental accounting concept. It basically means we count count our chickens before they hatch. In other words, when presented with options, the prudence concept would dictate we err on the side of caution. In practice, this means we should not overstate income, understate expenses, over-value assets or understate liabilities. To give an example, inventory is valued at the lower of cost or net realisable value (which is more or less what something sells for). While there are detailed accounting rules on inventory valuation, this is an example of the prudence concept at work. So, if the net realisable value was less that cost, inventory would be stated on the books at below cost. Another example is providing for bad and doubtful debts. For example, a business might think 2% of its customer debt will not be paid. This might not actually happen, but it is prudent to assume it will.
Okay, in my last post I explained the entity concept. Today, it’s the turn of the accruals concept. The accruals (or matching) concept is probably the one that most accounting students come across so often. It also underpins quite a few of the complex accounting standards. So what does the accruals concept entail?
The matching concept is probably a better name for it, as the accruals concept is all about matching costs and revenues. When cash comes in from sales, or is paid out for costs does not matter. Let me give you an example. Assume a business has a delivery van which cost €20,000 and will be good for 5 years. This means it helps to generate revenue (by delivering goods) for 5 years. The accrual concept would dictate that the cost is matched against the revenue generating capability. So, even if the van were bought and paid for right now, the cost in the accounts would be €4,000 per year for each of the five years. In this way, the cost is matched against revenues over the same time frame. Here’s another real life example. How do you think an airline like Ryanair accounts for its’s revenues? You buy the ticket weeks or months in advance, so can they record the sale once you pay? The answer is no, as no cost has been incurred. Once you fly, the cost is now incurred and the revenue (sale) can be recorded in the accounts, even though the cash has been paid in advance.
Watch out for more on the basic accounting concepts soon!
If you are learning accounting for the first time, one of the earlier things you should learn are basic accounting concepts. These are underlying rules which apply to accounting no matter how simple or complex the business or (to the best of my knowledge) the location.
One of these concepts is called the entity concept. In accounting, financial statements (e.g. income statement, statement of financial position (balance sheet)) need to be prepared for each business entity or group of entities under common control. When we think of large companies this is probably a simple enough concept to grasp. Companies are by nature separate legal entities too, and costs and revenues for each legal entity are normally easy enough to identify. In large groups, the entities are combined to prepare financial statements for the group as a whole. When we get down to the typical one-man-show type sole trader, things can get a bit blurred. But, the sole trader is probably the best example to explain the entity concept. For the sole trader, the entity concept would dictate that all business and personal expenses must be separated. Here’s an example. Let’s say a sole trader makes a business trip which means an overnight stay in a hotel. Let’s assume his/her partner comes along. Should any costs associated with the partner be treated as expenses in the sole trader’s accounts? Of course, the answer is no. (But hotel rooms often cost the same for 1 or 2 persons you’re thinking – so make sure your partner’s name does not appear on any bills for the room!). I remember another example from my time in practice. Following a tax audit, the tax inspectors correctly disallowed a repair to a washing machine as a business expense. This would only be an expense in a laundrette or similar business.
So the key thing to remember about the entity concept is to isolate the business entity and only include costs and revenues associated with that entity. Any personal costs/revenues should not be included. Costs/revenues of other entities should be excluded in general too (unless you are looking at a group).