What is

Accrual Basis
Accounting?

Accounting Knowledge
Muhammad Imran MI
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Gracious, the Most Merciful.

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Muhammad (‫ )ﷺ‬is the true messenger
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Muhammad Imran MI
Accrual Basis Accounting.
Accrual basis accounting is a method of
recording accounting transactions for
revenue when earned and expenses when
incurred. This is distinct from the timing
of related cash flows. It's mandated by
Generally Accepted Accounting Principles
(GAAP) and International Financial
Reporting Standards (IFRS) for most
companies because it provides a more
accurate representation of a company's
financial performance and position over a
specific period.
Here’s a detailed breakdown of its key
components, principles, mechanics, and
implications:
I. Core Principles Driving Accrual
Accounting:
1. Revenue Recognition Principle:
o Concept: Revenue should be
recognized (recorded in the financial
statements) in the period in which it
is earned and realizable (or realized),
regardless of when cash is received.
o "Earned": The company has
substantially completed what it must
do to be entitled to the benefits
represented by the revenues (e.g.,
goods delivered, services performed).
o "Realizable/Realized": The amount of
revenue can be reasonably estimated,
and collection is reasonably assured
(realizable), or cash has already been
received (realized).
o Example: A software company signs a
$12,000 annual contract in January
 and receives the full payment upfront.
Under accrual accounting, it
recognizes $1,000 of revenue each
month throughout the year as it
provides the service, even though the
cash was received in January. The
initially received cash is recorded as
"Unearned Revenue" (a liability).
2. Matching Principle (or Expense
Recognition Principle):
o Concept: Expenses should be
recognized in the same period as the
revenues they helped generate,
regardless of when cash is paid. The
goal is to match efforts (expenses)
with accomplishments (revenues).
o How Expenses are Matched:
▪ Direct Association: Costs directly
linked to specific revenues are
expensed when the revenue is
recognized (e.g., Cost of Goods
Sold is expensed when the sale
occurs).
▪ Systematic Allocation: Costs
benefiting multiple periods are
allocated systematically over those
periods (e.g., Depreciation of
machinery, Amortization of
intangible assets, allocation of
Prepaid Insurance).
▪ Immediate Recognition: Costs that
cannot be linked to specific
revenues or future benefits are
expensed immediately (e.g.,
administrative salaries, utilities for
the current month).
 o Example: A company pays its sales
team commissions in January for sales
made in December. Under accrual
accounting, the commission expense is
recorded in December (when the
related sales revenue was earned),
creating an "Accrued Commission
Payable" liability at the end of
December.
II. Mechanics: Adjusting Entries
To ensure revenues and expenses are
recorded in the correct period under the
accrual basis, companies make adjusting
entries at the end of each accounting
period (e.g., monthly, quarterly,
annually) before preparing financial
statements. These entries never involve
cash directly but update income
 statement and balance sheet accounts.
They fall into two main categories:
1. Deferrals (Cash First, Action Later):
o Prepaid Expenses (Deferred
Expenses): Cash is paid before the
expense is incurred. Initially recorded
as an asset. Adjusting entries decrease
the asset and record the expense as it
is used up or expires.
▪ Examples: Prepaid Rent, Prepaid
Insurance, Office Supplies,
Depreciation (allocating the cost of
a long-term asset).
▪ Entry Example (Insurance): Initial
payment: Debit Prepaid Insurance,
Credit Cash. Adjusting entry: Debit
Insurance Expense, Credit Prepaid
Insurance.
 o Unearned Revenues (Deferred
Revenues): Cash is received before the
revenue is earned. Initially recorded
as a liability. Adjusting entries
decrease the liability and record the
revenue as it is earned.
▪ Examples: Customer deposits,
subscription fees received in
advance, gift cards issued.
▪ Entry Example
(Subscription): Initial receipt:
Debit Cash, Credit Unearned
Subscription Revenue. Adjusting
entry: Debit Unearned
Subscription Revenue, Credit
Subscription Revenue.
2. Accruals (Action First, Cash Later):
o Accrued Revenues (Accrued
Assets): Revenue is
earned before cash is received.
Adjusting entries record the revenue
and a corresponding receivable
(asset).
▪ Examples: Services performed but
not yet billed, interest earned on
investments but not yet received.
▪ Entry Example
(Services): Adjusting entry: Debit
Accounts Receivable, Credit
Service Revenue. (Later, when
cash received: Debit Cash, Credit
Accounts Receivable).
o Accrued Expenses (Accrued
Liabilities): An expense is
incurred before cash is paid. Adjusting
 entries record the expense and a
corresponding payable (liability).
▪ Examples: Salaries earned by
employees but not yet paid,
interest expense incurred on loans
but not yet paid, utilities used but
not yet billed.
▪ Entry Example
(Salaries): Adjusting entry: Debit
Salary Expense, Credit Salaries
Payable. (Later, when paid: Debit
Salaries Payable, Credit Cash).
III. Impact on Financial Statements:
• Income Statement: Provides a more
accurate measure of a company's
profitability for a given period by
matching revenues earned with expenses
incurred during that period. Net income
 reflects economic performance, not just
cash inflows/outflows.
• Balance Sheet: Presents a more realistic
picture of a company's assets (including
receivables and prepayments) and
liabilities (including payables, accrued
expenses, and unearned revenue) at a
specific point in time. This gives a better
view of the company's financial position.
• Statement of Cash Flows: Becomes
essential under accrual accounting. Since
the Income Statement doesn't track cash
directly, the Statement of Cash Flows is
needed to reconcile net income (accrual
basis) back to the actual change in cash
during the period and to show cash
inflows/outflows from operating,
investing, and financing activities.
 IV. Advantages of Accrual Basis
Accounting:
• Accuracy: Reflects the economic reality of
transactions, not just cash movements.
• Comparability: Allows for better
comparison of financial performance
between different periods and different
companies.
• Predictive Value: Financial statements
prepared using accrual accounting are
generally considered more useful for
forecasting future performance.
• Compliance: Required by GAAP and IFRS
for external reporting for most entities.
V. Disadvantages/Challenges of Accrual
Basis Accounting:
• Complexity: Requires more sophisticated
bookkeeping and accounting knowledge
than cash basis.
• Estimates & Judgments: Relies on
estimates (e.g., bad debt expense,
warranty liabilities, asset useful lives for
depreciation), which can introduce
subjectivity.
• Disconnect from Cash Flow: A profitable
company (on paper) could still face cash
flow problems if it doesn't collect its
receivables promptly or has large upfront
cash outlays classified as assets. Close
monitoring of the Statement of Cash
Flows is vital.
VI. Contrast with Cash Basis:
• Cash Basis: Records revenue only when
cash is received and expenses only when
cash is paid.
• Simplicity: Easier to maintain.
• Limitations: Can be misleading as it
doesn't match revenues with the
expenses incurred to generate them. Can
be easily manipulated by delaying or
accelerating cash payments/receipts near
period-end. Not compliant with
GAAP/IFRS for most companies. Often
used by very small businesses or for
personal finances.
In Conclusion:
Accrual basis accounting provides a
comprehensive and standardized
framework for recognizing revenues and
expenses based on economic substance
 rather than cash timing. Through the
application of the revenue recognition
and matching principles, facilitated by
adjusting entries, it produces financial
statements that offer a more accurate and
comparable view of a company's financial
performance and position, making it the
standard for meaningful financial
reporting.

Cash Basis Accounting.

Core Concept:
Cash Basis Accounting is a simple
accounting method where:
1. Revenue is recognized only when cash
is RECEIVED. It doesn't matter when the
goods were delivered or the services
 were performed. If the cash hasn't hit the
bank account (or been received
physically), it's not recorded as revenue
yet.
2. Expenses are recognized only when
cash is PAID. It doesn't matter when the
expense was incurred or when the bill
was received. If the cash hasn't left the
bank account, it's not recorded as an
expense yet.
In Simple Terms:
Think of it like balancing your personal
checkbook. You only record income when
a deposit clears, and you only record an
expense when you write a check or
money leaves your account. It tracks the
actual flow of cash in and out of the
business.
 Key Characteristics:
• Focus on Cash Flow: Directly reflects the
cash position of the entity.
• Simplicity: Generally easier to maintain
than accrual accounting, as it doesn't
require tracking receivables (money
owed to you) or payables
(money you owe).
• Timing: The timing of revenue and
expense recognition depends entirely on
when cash changes hands.
Example:
• You provide consulting services in
December and send an invoice for $1,000.
• Your client pays you the $1,000 in
January.
• Under Cash Basis: You recognize the
$1,000 revenue in January, when the cash
was received.
• You receive your electricity bill for $200
in March (for electricity used in March).
• You pay the $200 bill in April.
• Under Cash Basis: You recognize the $200
expense in April, when the cash was paid.
Who Uses It?
• Small Businesses: Often used by sole
proprietors, freelancers, and small
businesses with simple operations,
primarily because of its ease of use.
• Individuals: Most individuals use a form
of cash basis accounting for their personal
finances.
Advantages:
• Easy to Understand and Use: Requires
less complex bookkeeping.
• Tracks Cash Directly: Clearly shows how
much cash the business actually has on
hand.
• Simpler Tax Calculation (Potentially): For
some small businesses in certain
jurisdictions, tax obligations might align
more closely with cash flows (though tax
rules can vary significantly).
Disadvantages:
• Doesn't Accurately Reflect Profitability: It
doesn't match revenues earned with the
expenses incurred to generate those
revenues within the same period. This
can give a misleading picture of the
business's actual performance during a
specific period. (In the example above, the
 December work generated revenue
recorded in January).
• Doesn't Show the Full Economic
Picture: Ignores accounts receivable
(money owed by customers) and
accounts payable (money owed to
suppliers), which are important
indicators of short-term financial health.
It also doesn't typically account for non-
cash items like depreciation.
• Not GAAP/IFRS Compliant: Generally
Accepted Accounting Principles (GAAP)
and International Financial Reporting
Standards (IFRS) require most businesses
(especially larger or publicly traded ones)
to use the Accrual Basis of accounting, as
it provides a more accurate
representation of financial performance
and position.
Contrast with Accrual Basis:
The opposite of cash basis is Accrual Basis
Accounting, where revenue is recognized
when earned (regardless of when cash is
received) and expenses are recognized
when incurred (regardless of when cash
is paid). Accrual basis provides a better
matching of revenues and expenses.
In summary, Cash Basis Accounting is a
straightforward method focused purely
on cash inflows and outflows, suitable for
very small entities but generally not
providing the comprehensive financial
picture required by larger businesses or
external stakeholders.