Business transactions can be recorded with one of two methods; Cash Basis or Accrual Basis.

Cash Basis

When a company uses the Cash Basis approach, they only record transactions when cash is involved (i.e. cash is received, or cash is payed out). When the company receives cash, they record it as Revenue. When cash is paid out, it gets recorded as an expense. It should be noted that accounting under the Cash Basis is NOT acceptable under GAAP, but some small businesses may use this method as it is easier to keep track of these limited transactions.

Accrual Basis

A company that uses an Accrual Basis method of accounting records transactions as they occur. What this means is as Revenues are earned they get recorded, and as Expenses are incurred, they get recorded. Most companies use this method. Because revenues and expenses are recorded as they occur, it does not matter when the transaction occurs (when cash is received, or paid).

The primary difference between these two methods of accounting is the timing of the event; when the transaction is recorded.

When using the Accrual Basis, there are three important fundamentals that help with understanding the difference; Time Period Concept, Revenue Recognition, and Expense Recognition.

The Time Period Concept works under the assumption that business reporting can be broken into small sections of time (i.e. monthly, quarterly, annualy). These periods do not have to be consistent with a calendar year, many businesses (and governments) operate on a fiscal year. A fiscal year is any 12 consecutive month period (it could start April 1 and end March 31).

Revenue Recognition is a requirement that companies should record revenue when it is earned, and establish how much revenue should be recorded. A company cannot record revenue before it is earned! The company must also record the amount they earned, regardless of a discount they offer. For example is Shoe Burger normally sells Yum Meal for $5, but they decide to have a fire sale and sell Yum Meal for $4 this week, they must record the sale of Yum Meal at $4; this is the revenue they earned.

Expense Recognition is related to expenses. Similar to Revenue Recognition, it dictates how to account for expenses. Expenses should be recorded when they are incurred. These expenses will be matched with revenues of the same period. What this means is Expenses will be subtracted from Revenues for the same period. This ensures continuity/consistency.