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Cash Versus Accrual Basis of Accounting

There are two different timings that are used in accounting to record revenues and expenses: cash basis and accrual basis. When to recognize (or realize) revenue depends on which accounting basis is used by the business. The first accounting basis we will discuss is cash basis of accounting. The difference between the cash basis and accrual basis of accounting is discussed in detail in Lesson 3. It is included here because we use the accrual basis of accounting beginning in Lesson 1.

Cash Basis of Accounting

The cash basis records revenues for the period in which cash is received for the goods sold or services rendered, and records expenses for the period in which cash is paid for the goods and services used. Therefore, cash has to change hands for a business to realize revenue and/or expenses. The cash basis is used by individuals and some small businesses.

Accrual Basis of Accounting

All transactions in this course will be recorded using the accrual basis of accounting.

The accrual basis records revenues for the period in which they are earned and records expenses for the period in which they are incurred, without regard to whether cash has been received or paid. Revenues are realized when the goods are sold or services rendered (or both), and expenses are recognized when the goods or services (or both), are used up, not when the cash changes hands between the parties. We will be recording transactions using the accrual basis of accounting.

When Are Revenues and Expenses Recorded?

Revenues are recorded when earned, not necessarily when the cash is received.

Expenses are recorded when they are incurred, not when the company paid for them.

Example 1.8
Assume MM TAX completes a tax return for a client, and the client promises to pay the fee of $2,500 in the future. Even though MM TAX is not receiving the fee now, the $2,500 fee that the client will pay in the future needs to be recorded now in the accounting records for MM TAX as revenue. This is true because the company earned fees by rendering services. What about the client? The client needs to record $2,500 of fees that he will pay in the future as an expense now. This is true because the client used up the services now. Does this make sense to you? Is it true that you first earn and get paid later?  
Note: The most common mistake that students make is that they equate revenues and expenses with cash. They think that you cannot have revenue without receiving cash, or you cannot have expense without paying cash. This is not the case. Make sure you have a clear understanding about the differences among revenues, expenses, assets, liabilities, and owner’s equity.
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