Accrual versus Cash-Basis Accounting

There are two ways companies can keep their accounting books - Accrual- and Cash-Basis. The accrual basis is used by most companies; only very small businesses use cash-basis.

Under the accrual method, expenses and revenue are recognized in the period they occur regardless of whether a cash transaction has occurred.  For example, if a sale is made in January but payment is not expected until February, the revenue from the sale would be recognized in January (when it was earned) and the amount due to the company is recorded (accrued) in accounts receivable.  Below are the Journal entries for the "sale on account" and the "payment on account".

Notice that the first entry above recognizes the sale in January, when it actually occurred. This method matches the revenue from the sale to the expenses incurred during the same period.

On the other hand, under the cash-basis method, the revenue would not be recorded until February when the cash is actually received, as in the example journal entry below.

While this method is easier and requires fewer journal entries, the sale revenue would not be matched-up to the expenses the company incurred to make the sale possible.  For example, consider the salesperson's salary who made the sale. Assume payroll expense is recorded in January. Since the revenue is not recognized until the next period (month), the accounting records do not portray a true picture of what actually occurred.

Under the cash-basis method, this mismatching of expenses and revenues would also occur if payment was received right away (in January), but the salesperson's salaries where not paid until February.

Generally Accepted Accounting Principles (GAAP) require that all public companies use accrual accounting. One reason for this is that a truer indication of a companies financial stability and income generating activities is reported giving investors and other interested parties better information to make informed decisions.