Reading: Lesson 2 - Cash versus accrual basis accounting

Professionals such as physicians and lawyers and some relatively small businesses may account for their revenues and expenses on a cash basis. The cash basis of accounting recognizes revenues when cash is received and recognizes expenses when cash is paid out. For example, under the cash basis, a company would treat services rendered to clients in 2010 for which the company collected cash in 2011 as 2011 revenues. Similarly, under the cash basis, a company would treat expenses incurred in 2010 for which the company disbursed cash in 2011 as 2011 expenses. Under the “pure” cash basis, even the purchase of a building would be debited to an expense. However, under the “modified” cash basis, the purchase of long-lived assets (such as a building) would be debited to an asset and depreciated (gradually charged to expense) over its useful life. Normally the “modified” cash basis is used by those few individuals and small businesses that use the cash basis.

Because the cash basis of accounting does not match expenses incurred and revenues earned, it is generally considered theoretically unacceptable. The cash basis is acceptable in practice only under those circumstances when it approximates the results that a company could obtain under the accrual basis of accounting. Companies using the cash basis do not have to prepare any adjusting entries unless they discover they have made a mistake in preparing an entry during the accounting period. Under certain circumstances, companies may use the cash basis for income tax purposes.

Throughout the text we use the accrual basis of accounting, which matches expenses incurred and revenues earned, because most companies use the accrual basis. The accrual basis of accounting recognizes revenues when sales are made or services are performed, regardless of when cash is received. Expenses are recognized as incurred, whether or not cash has been paid out. For instance, assume a company performs services for a customer on account. Although the company has received no cash, the revenue is recorded at the time the company performs the service. Later, when the company receives the cash, no revenue is recorded because the company has already recorded the revenue. Under the accrual basis, adjusting entries are needed to bring the accounts up to date for unrecorded economic activity that has taken place. In Exhibit 14, shown below, we show when revenues and expenses are recognized under the cash basis and under the accrual basis.