Procedural Conventions - the Accrual Convention

Procedural conventions - The accrual convention

The realization convention which asserts that gains in value may not be recognized until the occurrence of a transaction is reinforced by the accrual convention, which applies equally to revenues and expenses.

The accrual convention makes the distinction between the receipt of cash and the right to receive cash, and the payment of cash and the legal obligation to pay cash, for in accounting practice there is usually no exact coincidence in time between cash movements and the legal obligations to which they relate.

Let us examine, firstly, the manner in which the accrual convention applies to revenues. Revenue may be defined as the right to receive cash, and accountants are concerned with recording these rights. Cash receipts may occur instantaneously and also as follows:

(a) before a right to receive arises;

(b) after the right to receive has been created;

(c) cash may be received in error.

The accrual convention provides a guideline to the accountant as to how to treat these cash receipts and the rights related thereto.

Example

Mrs Smith is an old lady who occupies a flat owned by Mereworth Properties Ltd. The rent is payable monthly in advance on the 1st day of each month, and amounts to £25 a month. She is very forgetful, and rarely does a month pass without some complication in the payment of her rent.

On 1 January she sends her cheque for £25 in respect of the rent due for January. This rent is due and payable to the company, and must be included in its revenue for that month. On 10 January Mrs Smith sends another cheque for £25, thinking that she had not paid her rent for January. This is a cash receipt to which the company is not presently entitled, and it must either be returned to Mrs Smith, or it may be kept on her behalf as a payment in advance of her February rent-but only if she agrees. The accountant returns her cheque saying that she has already paid her rent for January, and she receives this letter on 20 January. She forgets to pay her rent on 1 February. The accountant is obliged to include the rent due in February in the revenue for that month, even though it is only ultimately paid on 15 March. Until Mrs Smith has paid her rent for February, she will be a debtor of the company for the rent owing.

Similar rules apply to the treatment of expenses incurred by the firm. Expenses may be defined as legal obligations incurred by the firm to pay in money or money's worth for the benefit of goods or services which it has received. Cash payments may occur instantaneously and as follows:

(a) before they are due for payment;

(b) after due date for payment;

(c) cash may be paid in error.

The accrual convention requires the accountant to treat as expenses only those sums which are due and payable. If a payment is made in advance, it must not be treated as an expense, and the recipient is a debtor until his right to receive the cash matures. Cash paid in error is never an expense, and until it is recovered the person to whom it was paid is also a debtor. Where an expense had been incurred, however, and no payment has been made, the expense must be recorded, and the person to whom the payment should have been made is shown as a creditor.

The importance of the accrual convention as regards record-keeping and the presentation of financial accounting statements is critical.


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Read on: Procedural Conventions - the Realization Convention

Procedural conventions - The realization convention

The realization convention is also closely related to the cost convention, for as the recorded value of an asset to the firm is determined by the transaction which was necessary to acquire it, so any change in its value may only be recognized at the moment the firm realizes or disposes of that asset. The realization convention reflects totally the historical origin of accounting as a method for recording the results of transactions. To an accountant there is no certainty of income until a sale has been made: hence, increases in value which have... see: Procedural Conventions - the Realization Convention