ACCRUAL BASIS OF ACCOUNTING

Accrual accounting records the effect of a business transaction as it occurs. When the business performs a service, makes a sale, or incurs an expense, the accountant records the transaction even if it receives or pays no cash. Net income from this activity equals the amount of cash received from customers minus the amount of cash paid for raw materials, labor, and the services of production facilities. If the entire operating cycle occurred in one accounting period, few difficulties would arise in measuring operating performance. Net income would equal cash inflows minus cash outflows related to these operating activities. However, firms acquire raw materials in one accounting period and use them in several future accounting periods. They acquire buildings and equipment in one accounting period and use them during many future accounting periods. Firms commonly sell goods or services in an earlier period than the one in which customers pay. Firms often consume resources or incur obligations in one accounting period and pay for those resources or settle those obligations in subsequent periods. Under a cash basis of accounting, a firm recognizes revenue when it receives cash from customers and recognizes expenses when it pays cash to suppliers, employees, and other providers of goods and services. Because a firm’s operating cycle usually extends over several accounting periods, the cash basis of accounting provides a poor measure of economic performance for specific periods of time because it provides a poor matching of resources earned (revenues) with resources used (expenses). To overcome this deficiency of the cash basis, both U.S. GAAP and IFRS (International Financial Reporting Standards) require that firms use the accrual basis of accounting in measuring performance. Under the accrual basis of accounting, a firm recognizes revenue when it meets the following two criteria:

• It has completed all (or substantially all) of the

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