There are two methods generally used to do accounting. One is accrual accounting and the other is the cash basis of accounting. Let's compare the two starting with accrual accounting. Transactions are recorded in the period in which they occur. We record revenue in that period in which it is earned, not just when cash is received. We record expense in the period in which it is incurred, not just when cash is paid For the cash basis of accounting, revenues are recorded when cash is received expenses are recorded when cash is paid. The result of this message is our financial statements are less accurate. Revenues and expenses reported in the month in which cash is received or paid might not provide .
Investors and creditors with the best performance information about a company and likely lead to overstated or understated amounts on our balance sheet. Thus the cash basis of accounting is not GAAP approved and cannot be used for any company that is required to prepare financial statements in accordance with GAAP. Usually it is used by small businesses and hobbyists who don't know anything about accounting. After just one accounting course: college students would know enough not to operate a business using the cash basis of accounting. Let's look at an example: Assume you are a realtor. You talk on the phone all during the month of July to close a sale that earns you $5000. .
You get paid in August. You receive July's cell phone bill of $100 in August and you pay that bill in September. So let's look about how these will be recorded under accrual accounting and the cash basis of accounting. Under accrual accounting both the revenue of $5000 and the expense of $100 would be recorded in the month of July because the revenue was earned in July and the expense was incurred in July. Under the cash basis of accounting, revenues and expenses are all over the place. The revenue of 5000 would be earned in August and the expense of $100 would be recorded in September. Basically it would look like you did absolutely nothing during the month of July. .
Do you see the problem with a cash basis? Your investors and creditors would have less valuable information because it doesn't reflect which who actually did during the month of July.