Cash Basis Vs Accrual Basis Of Accounting – Definition
The cash basis and the accrual basis are the two basic methods of accounting. Each method identifies a different set of rules for recognizing revenues and expenses. The accrual basis of accounting means that revenues, expenses, and other changes in assets, liabilities, and owners’ equity are accounted for in the period in which the economic event takes place, not when the cash inflows and outflows take place. Alternatively, the cash basis of accounting means that revenues and expenses are not recognized until the cash is received or paid.
The Accrual Basis Of Accounting
As we noted, the best matching of revenues and expenses takes place when the accrual basis of accounting is used. This means that the financial effects of transactions and economic events are recognized by the enterprise when they occur rather than when the actual cash is received or paid by the enterprise. For example, sales are recognized as revenues when they are made, and services are recognized when they are performed, regardless of when the cash from that sale or service is actually collected.
With the accrual basis of accounting, if cash, such as a deposit or a down payment, is received before the actual sale or the performance of a service, no revenue is recognized until the sale is made. Instead, a liability to perform a future service or to deliver a product is recognized at the time the cash is received. This liability is usually referred to as unearned revenue. When the service is finally performed or the sale is made, the revenue is then recognized, and the liability is decreased.
Expenses are recognized in a similar manner. That is, expenses are considered to be incurred or used when the goods or services are consumed by the enterprise, not necessarily when the cash outflow takes place. For example, the Carson corporation records as a June expense the salaries earned by its employees in that month, even though those salaries may not be paid until July. This is accomplished by recording Salaries Payable in June. When June’s salaries are paid in July, no expense is recognized at that time. Both a payable and Cash are reduced at that time, but no expense is involved. The decrease in the firm’s net assets and the corresponding expense were recorded in June.