ACCT 121 Lecture Notes - Lecture 3: Accrual, Financial Statement, Accounting
11 May 2020
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Accrual- versus Cash-Basis Accounting
• Under the accrual basis, companies record transactions that change a company's
financial statements in the periods in which the events occur.
• For example, using the accrual basis to determine net income means companies
recognize revenues when they perform services (rather than when they receive cash). It
also means recognizing expenses when incurred (rather than when paid).
• An alternative to the accrual basis is the cash basis. Under cash-basis accounting,
companies record revenue at the time they receive cash. They record an expense at the
time they pay out cash. The cash basis seems appealing due to its simplicity, but it often
produces misleading financial statements.
• For example, it fails to record revenue for a company that has performed services but
has not yet received payment. As a result, the cash basis may not recognize revenue in
the period that a performance obligation is satisfied.
• Accrual-basis accounting is therefore in accordance with generally accepted accounting
principles (GAAP). Individuals and some small companies, however, do use cash-basis
accounting. The cash basis is justified for small businesses because they often have few
receivables and payables.
Recognizing Revenues and Expenses
It can be difficult to determine when to report revenues and expenses. The revenue recognition
principle and the expense recognition principle help in this task.
Revenue Recognition Principle
• When a company agrees to perform a service or sell a product to a customer, it has
a performance obligation. When the company meets this performance obligation, it
recognizes revenue.
• The revenue recognition principle therefore requires that companies recognize revenue
in the accounting period in which the performance obligation is satisfied. A company
satisfies its performance obligation by performing a service or providing a good to a
customer.
Document Summary
It also means recognizing expenses when incurred (rather than when paid): an alternative to the accrual basis is the cash basis. Under cash-basis accounting, companies record revenue at the time they receive cash. They record an expense at the time they pay out cash. The cash basis seems appealing due to its simplicity, but it often produces misleading financial statements. For example, it fails to record revenue for a company that has performed services but has not yet received payment. As a result, the cash basis may not recognize revenue in the period that a performance obligation is satisfied: accrual-basis accounting is therefore in accordance with generally accepted accounting principles (gaap). Individuals and some small companies, however, do use cash-basis accounting. The cash basis is justified for small businesses because they often have few receivables and payables. It can be difficult to determine when to report revenues and expenses.
