Correct Answer:
The primary difference between the accrual basis and the cash basis of accounting is when revenues and expenses are recognized.
- Accrual Basis Accounting:
Revenues are recognized when they are earned (regardless of when cash is received), and expenses are recognized when they are incurred (regardless of when cash is paid).
Example: If a service is provided in December but payment is received in January, the revenue is recorded in December. - Cash Basis Accounting:
Revenues are recognized only when cash is received, and expenses are recognized only when cash is paid.
Example: If a service is provided in December but payment is received in January, the revenue is recorded in January.
Key Difference:
- Timing of Recognition:
Accrual basis aligns financial records with the economic activities of a business, while cash basis focuses on cash flow. - Regulatory Compliance:
Accrual basis is required under GAAP and IFRS for large businesses and public companies because it provides a more accurate picture of financial health. Cash basis is typically used by small businesses for simplicity.
