Financial statements are prepared under the Accruals Concept of accounting which requires that income and expense must be recognized in the accounting periods to which they relate rather than on cash basis. An exception to this general rule is the cash flow statement whose main purpose is to present the cash flow effects of transaction during an accounting period.
Under Accruals basis of accounting, income must be recorded in the accounting period in which it is earned. Therefore, accrued income must be recognized in the accounting period in which it arises rather than in the subsequent period in which it will be received. Conversely, prepaid income must be not be shown as income in the accounting period in which it is received but instead it must be presented as such in the subsequent accounting periods in which the services or obligations in respect of the prepaid income have been performed.
Expenses, on the other hand, must be recorded in the accounting period in which they are incurred. Therefore, accrued expense must be recognized in the accounting period in which it occurs rather than in the following period in which it will be paid. Conversely, prepaid expense must be not be shown as expense in the accounting period in which it is paid but instead it must be presented as such in the subsequent accounting periods in which the services in respect of the prepaid expense have been performed.
Accruals basis of accounting ensures that expenses are “matched” with the revenue earned in an accounting period. Accruals concept is therefore very similar to the matching principle.
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Which of the following are examples of accruals basis of accounting?
Depreciation is a way of matching the cost of a fixed asset with the revenue (or other economic benefits) it generates over its useful life. Without depreciation, the entire cost of a fixed asset would be recognized in the year of purchase.
Cash Flow Statement
Cash flow statements aim to present the cash flow effects of transactions that occur during an accounting period and are therefore not based on the accruals principle.
Prepaid expenses are not charged in the income statement of the accounting period in which they are paid but are instead expensed in the accounting periods to which they relate.
Provision for Warranty Claims
Provision for warranty claims and the associated expense is recognized in the accounting period in which the liability to settle claims arise rather than the period in which the claims are actually settled.