Describe accrual and cash accounting

Accrual Accounting

Accrual accounting measures the effects of transactions and events in the periods when they occur. In contrast, cash-basis accounting recognizes only cash receipts and disbursements. Under accrual accounting, firms recognize revenues when an arrangement satisfies the revenue recognition criteria, increasing net assets but not necessarily cash at the time of revenue recognition. Firms recognize expenses when an arrangement satisfies one of the two expense recognition criteria previously listed, decreasing net assets but not necessarily cash at the time of expense recognition. Accrual accounting often uses the amount of cash received or paid in some period to measure the amount of revenues and expenses recognized during the current period, but the timing of revenue and expense recognition does not necessarily coincide with the timing of cash receipts and disbursements.

Accrual accounting underlies the measurements of revenues and expenses on the income statement. Accrual accounting also affects balance sheet carrying amounts. Firms report economic resources with measurable future benefits as assets, even if the resources are not in the form of cash. Firms report obligations arising from economic benefits received in the past as liabilities, even though the firm has not yet paid cash. Shareholders' equity reflects changes in the residual interest of owners from transactions involving capital stock and from earnings
activities independent of when cash flows in or out of a firm.

Accrual accounting separates the timing of recognition in the income statement and the balance sheet from the timing of cash flows. Therefore, the need arises for a financial statement that reports the effects of operating, investing, and financing activities on cash flows.