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.