Accrual basis, cash basis

GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP) require accounting on the accrual basis, as opposed to the cash basis for accounting. In cash-basis accounting, rev¬enues are recorded when the monies are received. Expenses are recognized and recorded only when they are paid. In other words, revenues and expenses are recorded only when there is a movement of cash either into or out of the firm, respectively. The use of cash-basis accounting is found in only a few types of businesses, namely restau¬rants, medical offices, and legal firms.

Accrual-basis accounting is based upon GAAP, primarily the revenue and matching principles. The revenue princi¬ple requires that revenues be recognized and recorded when they are earned; this may not be at the same time that the revenues are received. For example, suppose a firm sells a computer on credit in December 1999, and the customer pays for the purchase in January 2000. Using the accrual basis, the sale and revenue is recorded when the transaction occurs—that is, in 1999. When payment from the customer is received in the next year, this is an entirely separate transaction and is recorded with the other transactions of the firm for the year 2000. (If cash-basis accounting were used, the firm would not record the computer sale in 1999, although that is when the sale was made. It would record the computer sale in 2000, because that is when the firm received payment for the computer. Transactions in cash-basis accounting are not recorded unless there is either a receipt or payment of money.)

It is impossible for a firm to generate revenue without incurring some sort of expense. When a good is sold, the expense account—COST OF GOODS SOLD—is debited (increased). If a service is performed, labor and/or supplies expense is debited. The matching principle requires that the expenses incurred in the generation of a firm’s revenue for a particular time period be recorded (included) in the same time period as the revenues to which they are related. For example, suppose a firm receives its telephone bill in January for its telephone expense that month, and the firm pays that bill two months later, in March. Even though the expense is paid in March, it is a January expense, not a March expense. The matching principle requires the expense to be recorded in January.

It is evident from the examples above that an accurate measurement of a firm’s periodic revenues and expenses in only realized with accrual-basis accounting. In the accrual basis, revenues and expenses are recorded when the sale is made and the expense is incurred. Cash-basis accounting ignores the concept of periodicity by recording revenues and expenses only when money changes hands. For this reason, accrual-basis accounting is generally accepted.