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Accrual Concept

An accounting concept which dictates that revenues and costs/expenses should be recorded as they are earned or incurred and they shouldn't be recorded when money is received or paid.

In other words, according to this concept or principle an accountant of business should record expenses and revenues in the books of accounts when these expenses and revenues are incurred or earned not when the money is paid as expense or money is received as income

EXAMPLES:

Prepaid Expenses
For example a business has to pay $2000 as telephone prepaid charges, but at the end of accounting period the business has only used up the service for $500 and remaining $1500 pertaining to the next year. In this case, business has to record only $500 as expense because it has incurred only that expense

Accrued expenses
Another example wherein a business has used service of telephone worth $500 and at the end of accounting period it has not yet paid this expense, the business is now required to record $500 as expense because it has incurred that amount of expense

Unearned income
A telephone company has received $1000 as telephone fee in advance from one of its customers, but at the end of accounting period the customer has used telephone service for $400. Since the customer has used up telephone service for $400 at the end of accounting period, the company can only record $400 as revenue not $1000 because company has, actually, earned $400

Accrued income
A telephone company has provided the service for $2000 and at the end of accounting period the customer has used service costing $2000, but he has paid $1500. Since the company has earned $2000, It will record the full $2000 as revenue

Adjusting Entries

Since the normal journal or double entries are made when transactions take place and with the actual amount of money paid or received, we need to make some adjusting entries at the end of accounting period (e.g. a year) to convert the amounts of these transactions into accrual basis of accounting in the books of accounts. Accrual basis accounting is the principle of recording expenses and revenues in a period to which these expenses and revenues actually relate

Why do we need to make adjusting entries?

As previously mentioned the adjusting entries are required to allocate the expenses and revenues to the appropriate financial period (e.g. a year)

Let’s assume a business needs to pay $3000 telephone bills for a year

Business paid 2500$ in the start of year and recorded this transaction. At the end of the year business owes $500

Business used the expense = $3000
Business paid the expenses=$2500


Now assume that business paid $3500 in the start of year and recorded this transaction. This payment include $500 advance for the next year

Business used the expense =$3000
Business paid the expense=$3500

In both cases, the business was supposed to record only $30,000 respectively, but the business has recorded $2500 and $3500 at the time of payment. What to do now? Obviously, at the end of accounting period business will make one or more adjusting entries in its books of accounts to rectify these expenses balances and to show the correct balances of expenses and revenues in its financial statements


There are four main types of adjusting entries:

1) Outstanding/Accrued/Payable/Unpaid Expenses
Expenses incurred but not yet paid by the business

2) Prepaid/Paid in advance/Un-expired Expenses
Expenses paid but not yet incurred by the business

3) Outstanding/Accrued/receivable Revenue
Revenue or income earned but not yet received by the business

4) Unearned/Received in advance Revenue
Revenue received but not yet earned by the business