There are two basic methods of accounting that businesses use to track and report revenues: the cash basis and the accrual basis. Under the accrual basis, revenues are recorded on a company's income statement when they are earned, regardless of when cash is actually received. Similarly, under the accrual method, expenses are matched with related revenues and recorded when they occur, not when they are paid for.
By contrast, under the cash basis, revenues are not recorded until cash is actually received in hand, and expenses aren't recorded until they're actually paid.
Accrual accounting at work
Let's say a company sells $10,000 worth of products on March 1 and receives payment for those products on April 30. Under the cash method, you'd record only that $10,000 once you receive the money in hand. Under the accrual method, you'd record that $10,000 as revenue the day the sale is made. It doesn't matter when you receive the money; you're obligated to report it as earned revenue as soon as you become aware of the sale.
The same concept applies to expenses. If a company receives a bill for $500 on May 1, under the cash method, you'd record the expense the day you pay the bill, which could be a month or more later. Under the accrual method, you'd record that $500 on May 1, the day the bill was received.
Advantages of the accrual basis
The accrual basis of accounting provides a more accurate picture of a company's profitability during a specific accounting period. An income statement prepared using the accrual method will report all revenues earned during the period it seeks to cover, as well as all of the expenses incurred to bring in those revenues. The accrual basis of accounting also shows how well a company is faring financially at a given point in time, because under this method, all earned assets and liabilities must be reported.
The matching principle
The matching principle is a component of the accrual method and requires that companies match revenues with the expenses incurred to earn them by reporting both at the same time. By recognizing expenses in the period during which they are incurred, a company can see how much money it is spending to bring in revenues.
Choosing between the accrual and cash basis
Small businesses generally have the option to choose between the accrual and cash methods of accounting, and many opt for the cash basis because it is less complex. Businesses that stock inventory, however, are almost always obligated to use the accrual method. Similarly, companies with sales of over $5 million per year must do their accounting on an accrual basis.
If you came to this article looking for information on stocks, we can help. Check out our Broker Center for answers to your questions about how to get started investing.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at firstname.lastname@example.org. Thanks -- and Fool on!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.