It is immediately clear that for financial statements to be meaningful, amounts of dissimilar items must be stated in similar units. Money becomes the obvious choice of “similar units”. By converting different kinds of objects into monetary amounts, they can be dealt with arithmetically. This is called the “money-measurement concept” and is a fundamental principle of accounting.

This is great, but the problem is not yet solved. An asset may be recorded in dollars and cents (or whatever currency is appropriate for the country in which you live), but at what value? If I were allowed to choose the value I thought was appropriate for my assets, my tendency would be to state their value at the highest amount possible. That way, my financial statement would indicate that my business was strong, healthy, and worth a lot of money. Remember the “accounting equation”:

ASSETS – LIABILITIES = EQUITY

Higher assets mean higher equity. Wonderful, but what if I’m wrong? My banker and my investors are trusting that my financial statements are stated accurately. Furthermore, it is not reasonable to expect that every reader of my financial statements can or should have to appraise my assets.

In order to avoid the subjectivity of market value, an objective way of valuing assets had to be established. This was solved by using the “historical cost” concept. This concept states that the numbers reported on accounting financial statements shall be recorded at the amount that was actually paid for an asset, i.e., historical cost. Therefore, accounting does not record what an asset is actually worth, that is, its market value. This works out okay because most businesses are using their assets to conduct operations and are not trying to sell them. When a business offers an asset for sale, or perhaps the entire business, an appraisal to determine fair-market-value of the assets must be performed.

So we (preparers of financial statements) are going to use money as a measurement system and we will record our assets at the amount actually paid for them. This will keep us out of trouble and make it easier to understand what others are doing.

You have read the definition of accrual vs. cash (above) so let’s use one of the most common examples of accrual accounting found in small businesses, i.e., Accounts Receivable and Accounts Payable. First, you must be familiar with how debits and credits work. If you need a quick review, click on this link for the Accounting Model:

http://www.reallifeaccounting.com/accounting_model.asp

Let’s say you are in the business of selling T-shirts. Today you sold four T-shirts for $10 each. Two of the T-shirts sold were paid for with cash,i.e., $20. The other two were sold “on account”. In other words, the customers said they would pay you later. These two transactions have to be recorded differently on your books. Here is the journal entry for the first transaction.

Does this make sense? Check it against the Accounting Model. You increased Cash and you increased Sales, so are the amounts recorded properly in the debit and credit columns?

How about the “pay you later” transaction? We call that a “receivable” because money is owed to the business. Here is how it looks in journal entry form:

Sales are said to be “accrued” when the payment for the goods or services is deferred to a later date. But, you might ask: Why are both the Cash and Accounts Receivable amounts listed in the debit column? It should be obvious that the General Ledger (GL) Sales account belongs in the Revenue section, but what section do the GL accounts, Cash and Accounts Receivable belong? They are Assets. Why? Because both of the items represent an economic resource that your company has possession and control over that will provide a future benefit. What happens when an Asset is increased? The Accounting Model tells us that
an increase of an Asset belongs on the “debit” side of the ledger.

Thirty days later your customers send you checks totaling $20 to pay for the T-Shirts. Here is how the transaction is booked:

What happened here? You received $20 Cash, put it in the bank, and you eliminated or canceled out the amount owed to you on the books.

Let’s look at Accounts Payable next. In this situation, we will assume that you bought some inventory (T-Shirts) for resale. You bought four T-Shirts altogether. You paid cash for two shirts and the other two you bought “on account”. Here is what it looks like in journal entry form:

You decreased the Liability and decreased Cash. These are examples of the difference between an Accrual transaction and a Cash transaction.

Which one is better? It is not a question of better, it is a question of accuracy. If you include all accrual transactions on your books, the reader will have a more complete understanding of what is going on in your business than if only Cash transactions are recorded. Think about it with our examples. The Accrual
transactions would show more Assets, more Liabilities and more Revenue than the strictly Cash transactions. This reflects all the activity going on instead of just a portion. This is why the Financial Accounting Standards Board (FASB) requires that financial statements that are prepared using Generally Accepted Accounting Principles (GAAP) use the Accrual method of accounting.