The most fundamental choice in accounting is when to record revenue and expenses. The two approaches — accrual accounting and cash accounting — give different answers and produce different financial pictures of the same business.
Cash accounting records transactions when cash moves. Revenue is recorded when payment is received, and expenses are recorded when payment is made. This is how most individuals think about money — if you haven’t been paid yet, it doesn’t count.
Accrual accounting records transactions when the economic event occurs, regardless of when cash moves. Revenue is recorded when it’s earned (the work is done or the goods are delivered), and expenses are recorded when they’re incurred (the benefit is received). GAAP and IFRS both require accrual accounting for financial reporting.
Why the difference matters — a worked example:
A consulting firm completes a 6,000 in wages during March, paid on April 5.
Under cash accounting, March shows: Revenue 0, Net Income 10,000, Expenses 4,000. March looks like nothing happened; April looks like everything happened.
Under accrual accounting, March shows: Revenue 6,000 (incurred), Net Income $4,000. April shows no revenue or expense from this project — just the cash movements. March reflects economic reality.
Why accrual accounting wins for reporting: It matches efforts (expenses) with results (revenues) in the same period. This is the revenue recognition principle — revenue belongs to the period when it’s earned, not when cash arrives. Without this matching, financial statements become unreliable for decision-making.
Why cash accounting still exists: It’s simpler. Small businesses, sole proprietors, and individuals often use it because they don’t need the precision of accrual accounting and the added complexity of adjusting entries. In the US, businesses with less than $25 million in average annual gross receipts can use cash accounting for tax purposes [citation needed]. It also answers a question accrual accounting doesn’t: “Do I have enough cash to pay bills right now?” — which is why even accrual-basis businesses need a cash flow statement.
The connection to the accounting cycle: Adjusting entries exist because of accrual accounting. If a business used cash accounting, it wouldn’t need accruals or deferrals — everything would be recorded when cash moved. The entire machinery of end-of-period adjustments is the cost of the more accurate picture that accrual accounting provides.