A problem with financial statements prepared on a cash basis is that they often present an inaccurate image of the firm’s financial position and its operating results for a particular period of time. This is because the cash inflow in one period may not be related to the cash outflow in that period. If a firm’s transactions are limited to cash revenue and expenditures, the cash basis essentially agrees with the accrual basis.
Accrual basis of accounting is an accounting method whereby revenues are recognized in the specific accounting period in which they are earned, without regard to the date of cash receipt, and expenses are assigned to the accounting period in which they are used to produce revenue, without regard to the date of cash payment. Therefore, accrual accounting deals not only with cash transactions but also with transactions and events that have cash consequences for an entity without involving present flows of cash.
The recognition of revenues, expenses, gains and losses and the related increase or decrease in assets and liabilities in the accounting period is the essence of accrual accounting. Under accrual basis accounting, revenue is generally recognized when a sale takes place or a service is performed, and expenses are recognized when the revenues they generated are recognized (i.e., expenses are matched with their corresponding revenues).