Accrual Basis versus Cash Basis
After external transactions and events are recorded for an accounting period, several ac- counts still need adjustments before their balances appear in financial statements. This need arises because internal transactions and events remain unrecorded. Accrual basis account- ing uses the adjusting process to recognize revenues when earned and to match expenses with revenues.
Cash basis accounting recognizes revenues when cash is received and records expenses when cash is paid. This means that cash basis net income for a period is the difference between cash receipts and cash payments. Cash basis accounting is not consistent with generally accepted accounting principles.
It is commonly held that accrual accounting better reflects business performance than in- formation about cash receipts and payments. Accrual accounting also increases the compar- ability of financial statements from one period to another. Yet cash basis accounting is use- ful for several business decisions—which is the reason companies must report a statement of cash flows.
To see the difference between these two accounting systems, let’s consider FastForward’s Prepaid Insurance account. FastForward paid $2,400 for 24 months of insurance coverage beginning on December 1, 2004. Accrual accounting requires that $100 of insurance expense be reported on December’s income statement. Another $1,200 of expense is reported in year 2005, and the remaining $1,100 is reported as expense in the first 11 months of 2006. Exhibit 3.2 illustrates this allocation of insurance cost across these three years. The accrual basis balance sheet reports any unexpired premium as a Prepaid Insurance asset.
A cash basis income statement for December 2004 reports insurance expense of $2,400, as shown in Exhibit 3.3. The cash basis income statements for years 2005 and 2006 report no insurance