by Michael Nnopu

Created on: July 05, 2009

Introduction

Business organizations are established to achieve several objectives. One of these objectives is the generation of profits from its activities for the owners, and one of the ways of determining profitability is the preparation of books of accounts.

The accounting records of an organization can be prepared by several methods, but the two most common are the accrual and cash basis. Although, there is also the commitment basis, but this third method is hardly used by accountants, therefore less popular than the previous two methods.

The Financial Accounting Standards Board (FASB) has developed some accounting concepts and principles which are known as Generally Acceptable Accounting Principles (GAAP). Two of these concepts: the matching concept and realization concept, are somewhat related to the accrual basis and cash basis accounting, and a proper understanding of these concepts will further help in appreciation of accrual and cash basis accounting.

The Matching Concept

This concept in its simplest form states that revenue should be matched with the expenses that produced it, or put in another form, expenses should be tied to the revenue it produced. This concept gives a clearer picture of the profitability and performance of an organization as expenses are tied to revenue that it produced, irrespective of when actual payment was made. Depreciation which is the practice of spreading the cost of a fixed asset over its useful life is a good example of the matching concept.

Realization Concept

To the accountant, profit is recognised or revenue is earned when the transaction is completed or when exchange has taken place. This can be further explained by the following example: when a product that cost $50 is sold for $60, the profit of $10 is recognised and recorded in the books, despite the fact that payment for the goods or service might take place at a later date.

According to Simons and Smith (1972), the realization principle provides that before revenue is realized: the earning process must be complete or virtually complete; and an arms-length market exchange must have taken place. Based on these criteria, revenue is generally recognised at the point of sale, that is, at the point when an arms-length transaction between two willing and competent parties has been completed (p. 22).

Accruals Basis Accounting

This is a major basis for recording accounting and financial transactions. Under the accruals basis, revenue

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