Unit
- Accrual basis: Revenues are recorded when earned, regardless of when cash is received. Expenses are recorded when incurred, not when paid. This aligns with the economic activity of the business rather than its cash cycle.
- Cash basis: Revenues and expenses are recorded only when cash is actually received or paid. This method is simpler but can misstate periodic performance, especially when there are lags between transactions and cash flows.
- GAAP requirement: Generally accepted accounting principles (GAAP) require accrual accounting for all publicly traded companies and most private entities that issue financial statements. Cash basis is only acceptable for very small businesses or personal finance.
- Impact on financial statements: Under accrual, the income statement shows earned revenues and incurred expenses, providing a better measure of profitability. The balance sheet includes assets and liabilities like accounts receivable and payable that are not captured under cash basis.
- Timing differences: Accrual accounting creates timing differences between net income and cash flow from operations, which are reconciled in the statement of cash flows using the indirect method. This helps analysts understand the quality of earnings.
- Example scenario: A company provides services in December but receives payment in January. Under accrual, revenue is recorded in December; under cash, in January. The accrual method shows the company's performance for the year more accurately.
- Advantages of accrual: Provides a more complete and timely picture of financial position and performance. Enables better matching of revenues and expenses, facilitates comparison across periods, and supports compliance with lending and regulatory requirements.
- Disadvantages of accrual: More complex and costly to maintain. Requires estimates and judgments, such as allowance for bad debts or useful lives of assets. Can be manipulated through aggressive revenue recognition or expense deferral.
- Revenue recognition principle: Under accrual accounting, revenue is recognized when it is both realized or realizable and earned, not when cash arrives. The core criteria include evidence of an arrangement, delivery has occurred, price is fixed, and collectability is reasonably assured.
- Expense matching principle: Expenses must be recorded in the same period as the revenues they help generate. For example, cost of goods sold is matched with related sales revenue, and commissions are expensed when the sale is recorded, regardless of when the commission is paid.
- Adjusting entries: At the end of each accounting period, accrual requires adjusting entries for items like prepaid expenses, unearned revenues, accrued revenues, and accrued expenses. These ensure that revenues and expenses are recorded in the correct period and that balance sheet accounts reflect true obligations and resources.
- Deferrals versus accruals: Deferrals involve cash received or paid before revenue or expense recognition, such as prepaid insurance or unearned revenue. Accruals involve revenue earned or expense incurred before cash changes hands, like accrued interest receivable or accrued wages payable.
Regulatory Requirement
Regulation: GAAP (ASC 105) and IFRS Conceptual Framework
Both frameworks mandate the use of accrual accounting for external financial reporting. The SEC requires publicly traded companies to file financial statements prepared under accrual basis. Non-compliance can result in restatements, penalties, and loss of investor confidence.
Quick Revision
- Accrual accounting records economic events when they occur, independent of cash flow.
- Cash basis is simpler but not GAAP-compliant for most entities.
- Accrual basis provides a more accurate measure of periodic performance.
- Statement of cash flows reconciles the difference between accrual net income and cash flow.