Accrual vs. Cash Basis Accounting

Overview

• What you’ll learn: The difference between accrual and cash basis accounting, the revenue recognition principle, the matching principle, and when each method is appropriate.
• Prerequisites: Lesson 5 — The Accounting Cycle Overview
• Estimated reading time: 15 minutes

Introduction

The Grand Historian records: In the great debate halls of the accounting academies, no question has provoked more heated argument than this: When should we record revenue and expenses? The answer defines two fundamentally different schools of thought — the accrual basis and the cash basis. Choose one, and you see a prosperous enterprise. Choose the other, and that same enterprise may appear to be barely surviving. Both tell the truth; they simply tell it at different times.

Cash Basis Accounting

Under the cash basis, revenue is recorded when cash is received, and expenses are recorded when cash is paid. It is beautifully simple — if money came in, it is revenue; if money went out, it is an expense.

Example: Cash Basis

A consultant performs $5,000 of work in December but receives payment in January:

Advantages

• Simple to understand and implement
• No need for adjusting entries
• Matches actual cash flow
• Useful for very small businesses and personal finances

Disadvantages

• Does not match revenue with the effort that generated it
• Can be manipulated by timing payments and collections
• Not accepted under GAAP or IFRS for most businesses
• Does not show the true economic picture of the enterprise

Accrual Basis Accounting

Under the accrual basis, revenue is recorded when earned (regardless of when cash is received), and expenses are recorded when incurred (regardless of when cash is paid). This is the method required by GAAP and IFRS for all but the smallest enterprises.

The Revenue Recognition Principle

Revenue is recognized when the performance obligation is satisfied — that is, when the good is delivered or the service is performed. The receipt of cash is irrelevant to the timing of recognition.

Under ASC 606 (the current GAAP standard), revenue recognition follows five steps:

1. Identify the contract with the customer
2. Identify the performance obligations
3. Determine the transaction price
4. Allocate the price to performance obligations
5. Recognize revenue as obligations are satisfied

The Matching Principle

Expenses must be recorded in the same period as the revenue they help generate. If a salesperson earns a commission on a December sale, that commission expense belongs in December — even if the commission is not paid until January.

Example: Accrual Basis

The same consultant who performs $5,000 of work in December:

Comparing the Two Methods

Adjusting Entries: Where Accrual Meets Reality

The accrual basis requires adjusting entries at the end of each period to ensure revenue and expenses are in the correct period. Four types of adjustments exist:

• Accrued Revenue: Revenue earned but not yet received or recorded (e.g., interest earned but not yet collected).
• Accrued Expenses: Expenses incurred but not yet paid or recorded (e.g., wages earned by employees but not yet paid).
• Prepaid Expenses (Deferrals): Cash paid before expense is incurred (e.g., insurance paid for 12 months in advance — each month, one-twelfth is recognized as expense).
• Unearned Revenue (Deferrals): Cash received before revenue is earned (e.g., subscription collected in advance — each month, a portion is recognized as earned).

Key Takeaways

• Cash basis records when cash moves; accrual basis records when economic events occur.
• The revenue recognition principle (ASC 606) requires revenue to be recorded when performance obligations are satisfied.
• The matching principle requires expenses to be recorded in the same period as the revenue they help generate.
• Accrual accounting requires four types of adjusting entries: accrued revenue, accrued expenses, prepaid expenses, and unearned revenue.
• GAAP and IFRS require accrual basis for all but the smallest entities.

What’s Next

In Lesson 7, you will learn about internal controls and ethics — the safeguards that protect the integrity of the accounting system from fraud, error, and human temptation.