The policy of recognizing
revenue in the accounting records when it is earned, and recognizing expenses
when the related goods (services) are used, is called the accrual basis. The
purpose of accrual accounting is to measure the profitability of the economic
activities conducted during the accounting period.
The most important
concept in accrual accounting is the matching principle. Revenue is offset with
all the expenses incurred in generating that revenue, thereby providing a
measure of the overall profitability of the economic activity. The alternative
of the accrual basis is the cash basis.
Under the cash basis of
accounting, revenue is recognized when the cash is collected from the customer,
rather than when the company sells goods or renders services. Expenses are
recognized when payment is made, rather than when the related goods or services
are used in business operations. The cash basis measures the amount of cash
received and paid out during the period, but does not provide a good measure of
the profitability of the activities during the period.
Case in Point: is the
airlines industry. The sell tickets in advance of scheduled flights. However, many
expenses relating to the flight, like fuel costs, salaries of staff, may not be
paid out until after the flight has occurred. So the cash basis would fail to
match revenue and all the expenses in the accounting period which the services
were rendered.
