Companies may prepare their income statements on either the cash basis or the accrual basis. Small businesses may choose the cash method of accounting so they can rely on income statements to better gauge cash flows, which are vital to their business operations, given that small businesses often have limited resources. Companies with sales above a certain level, however, must use the accrual method of accounting so they can more accurately report revenues when earned and expenses when incurred.
Using the cash basis for income statements, companies record revenues when they receive cash payments from customers. Sometimes customers may prepay companies for future product deliveries or services or make deposits to secure future purchases. Even though companies haven’t actually carried out a sale or rendered a service, they record the revenue upon receipt. Other times, customers may delay their payments after they have received a product or service, and companies won’t record the sale as a revenue until they have collected the cash from customers
Using the accrual basis for income statements, companies record revenues when earned and realizable. Revenues are earned when companies have physically delivered a product or performed a service. Thus, prepayments from customers are not recorded as revenues at the time. After-sale collections also don’t affect revenues because companies have already recorded revenues at the time of the sales. However, companies may not record a sale as revenue if future collections are doubtful and may not be realizable.
Using the cash basis for income statements, companies record expenses when they make cash payments. Sometimes companies prepay future expenses, but under the cash basis of accounting, they record all expenses at once in the current period. Other times, companies may delay cash payments for products or services they have received, and won’t record any expenses until they make the cash payments.
Using the accrual basis for income statements, companies record expenses when incurred to match with the revenues that the expenses help generate in the same periods. Thus, prepaid expenses are not reported as expenses at the time of the prepayments made, but rather recorded as assets and allocated over time as multi-period expenses. Companies also record an expense when they receive a product or service even though they are not paying for the product or service immediately. However, later payments have no effect on the expenses already incurred and recorded.