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Accrual Basis vs. Cash Basis

There are two principle methods of accounting that can be used to keep track of a business's income and expenses in the United States: cash-basis and accrual basis. These methods differ in timing for when transactions (such as sales and purchases) are recognized. 

Cash-basis: The cash-basis, or cash receipts and disbursements method of accounting, is typically used by small businesses. This method only requires that business record revenue and expenses at the time that cash is actually received or paid. Cash-basis is a much more simple way of recording transactions, and allows small business's to avoid having to learn and apply many of the complex accounting rules that have been developed under the accrual-basis. 

Accrual-basis: Under the accrual-basis, a business attempts to recognize revenue and expenses when they actual incur, as opposed to when the related cash changes hands. This means that sales are recorded when made, not when accounts receivable are collected, for example. Rules and principles under US-GAAP apply most extinsively to the complexities of accrual-based accounting, especially dealing with the appropriate timing for when and how revenues and expenses should be recorded. 

There are four differences in timing that occur under accrual-basis:

     a. Accrued revenue: Accrued revenue is revenue that is recognized before the actual cash is received. 
     b. Accrued expense: An accrued expense is an expense that has been incurred before cash is actually paid out. 
     c. Deferred revenue: When revenue is to be recognized some time after cash is received, we create an account called deferred revenue.
     d. Deferred expense: Deferred expenses are expenses that have been paid, but will be incurred after.

The SEC requires that all C corporations, partnerships which have a C corporation as a partner, and tax shelters use the accrual basis of accounting. The exception is farming businesses, qualified personal service corporations, or entities with gross receipts of not more than $5 million.1


References:

1. 26 U.S.C § 448

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