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An important decision faced by a new business is what accounting or bookkeeping method are they going to use to
track their revenue and expenses. If inventories are a major part of the business, the decision is made for
the business owner by the Internal Revenue Service (IRS) and the business is normally required to
use the accrual method of accounting.
The Cash Basis recognizes revenues (earnings) in the period the cash is received and expenses
in the period when the cash payments are made.
The Accrual Basis records income in the period earned and all expenses in the period incurred.
An easy example to help clarify the difference between the two methods is provided by how most of us
prepare and calculate our individual tax returns. We record our income as earned when we get our payroll
check (cash basis) and not each day we work and are actually earning our income (accrual basis). An easy example
related to expenses would be how you account for donations on your tax return.
You deduct the donations when actually paid (cash basis) and not at the time you make your
pledge (accrual basis).
Most accountants when asked will recommend that a business use the double entry bookkeeping system
and the accrual basis which is based on the revenue realization principle and a principle
called the matching concept. The revenue realization principle states that revenue
should be recorded when actually earned. The matching principle is recording the revenues earned
during a period using the revenue realization principle and matching (offsetting) the revenues
with the expenses incurred in generating this revenue. Why is this so important ? All businesses
small and large need information to determine how well or badly they are performing; however,
if this information is misleading it could lead to false conclusions and unnecessary actions.
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