Business transactions are recorded when they occur and not when the related payments are received or made. This concept is called accrual basis of accounting and it is fundamental to the usefulness of financial accounting information.
- An airline sells its tickets days or even weeks before the flight is made, but it does not record the payments as revenue because the flight, the event on which the revenue is based has not occurred yet.
- An accounting firm obtained its office on rent and paid $120,000 on January 1. It does not record the payment as an expense because the building is not yet used. While preparing its quarterly report on March 31, the firm expensed out three months' rent i.e. 30,00 [$120,000/12*3] because 3 months equivalent of time has expired.
- A business records its utility bills as soon as it receives them and not when they are paid, because the service has already been used. The company ignored the date when the payment will be made.
Accounting standards strictly require accounting on accrual basis. However, there is an alternative called cash basis of accounting. Under the cash basis events are recorded based on their underlying cash inflows or outflows. Cash basis is normally used while preparing financial statements for tax purposes, etc.
Written by Obaidullah Jan