One of the Fundamental Accounting Assumption used in preparation of financial statement of the three accounting assumptions mentioned in Accounting Standard 1 (AS 1) on Disclosure of Accounting Policies.
If this is not followed, the fact that it is not followed and the reason as to why it is not followed to be disclosed. This tells you the importance of Accrual Basis of Accounting.
All Companies were given a clear mandate to follow accrual basis of accounting, some 30 years back, nearly 3 decades ago. This is was made obligatory by Section 209 of the Companies (Amendment) Act, 1988.
WHAT DOES IT MEAN WHEN YOU SAY YOU ARE ACCOUNTING ON ACCRUAL BASIS?
It means, both revenues and costs are recorded and recognized as and when they are earned or incurred. These are then recorded in the financial statements of the period to which they relate.
All transactions and events are recorded in the financial statement as and when they occur, rather than recording them in the periods in which cash is received or paid by the enterprise.
To effectively measure the performance of anything, efforts and accomplishments should be matched. In similar way the efforts(costs) and accomplishments(benefits) of the enterprise are matched in the same period as they are incurred to get to know about the net effect, positive or negative of the enterprise’s performance. This net effect is measured in the form of net revenue/ profits.
The main difference between cash system and accrual system of accounting is that, in cash system of accounting, often cash receipts indicates the benefits of activities performed in the earlier periods.
For example: Production of a product, its Marketing and Sale would have happened in the year 2016, but cash on sale made would have been received in the year 2017. Cash expenses or outlays would indicate the activities of future periods.
Thus the three most essential features displayed by the accrual basis of accounting is as follows:
1) Revenue is recognized as and when it is earned
Sale of product, recognized as revenue, eventhough the collection happens at a later date.
Example: In the case of subscription income for periodicals or for companies providing video on demands, cash received should not be recognized as revenue, although payments by the customers would have been made one time. Hence, revenue has to be recognized as and when the service, distribution becomes due. Usually it is monthly.
Note: For the Revenue to be Recognized, Accounting Standards -9 on Revenue Recognition should also be referred.
2) In the case of costs, costs are matched against the revenue earned on a particular time period or to the period to which they relate, to determine the periodic net income or the performance.
Sometimes, companies recognize costs at a future date to inflate their profits or to show their business as more profitable. This should not be encouraged.
In the case of direct labor costs, costs are recorded as and when the product is produced.
Purchase of a machinery and charging depreciation on machinery is one such example where the machinery is depreciated to match it against the revenue earned from the products produced from the machinery.
Some costs are not directly related to the income, but contributes to generation of income in an indirect way. They are also charged to the expense as and when they become due. They are called as Period Costs.
Examples: Salary cost of an accountant, Rental Expense of Office Building, Telephone, Travelling Expenses, etc.
Hence irrespective of whether they are directly related to earning income, these costs are recorded in the period in which they are incurred or become due, although the payment may be made in advance or a future date.
3) Costs which are not charged to income are carried forward and are kept under continuous review.
Example of these costs are the Development costs, especially relevant for Software Industry, these costs are not expensed off in the P&L, rather they are carried as an asset. It is written off when the project viability comes under question and the project is dropped.
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