The need for an organization to keep accurate financial records is essential for the effective running of the business and as an indicator of performance and the economic health of the company. This can be achieved in one of two ways; the cash basis method or the accrual basis method.
The former captures expenses at the time they are paid and revenues when payment for goods or services is received. This is perhaps more familiar to those without knowledge of generally accepted accounting principles, because it more closely resembles personal financial management. Although credit and other fiscal instruments are used in some cases by individuals in their personal matters, most people ...view middle of the document...
” (Ristea, Doros, Ioanas, & Morega, 2010, p. 208).
When employing the accrual basis of accounting, financial events are recorded at the time they occur. For example; when a service is rendered to a customer, the company will generate an invoice and record this revenue at this time, even though it may be several weeks before payment is collected. This is done using the double entry bookkeeping method, in this example, with an entry in both an accounts receivable account and a service revenue account.
In the same way, the operating expenses for the company would also be recorded within the period they were incurred, and not necessarily at the time they were paid. An example of this is prepaid insurance. Insurance is typically paid for one year, in advance. The cost for this insurance would be paid in full at the effective date of the coverage period, however an amount would be expensed periodically over the life of the policy, typically monthly, to ensure this operating expense is more accurately reported.
The accrual method more closely resembles reality as it relates to the business activities of a company. It is for this reason that it is favored by both commercial accounting practices and generally accepted accounting principles.
Ristea, M., Doros, A., Ioanas, C., & Morega, D. (2010). Small and Medium-Sized Entities between the Accrual Basis of Accounting and Cash Accounting. Romanian Economic And Business Review, 5(4), 208-220.