State BPA Fundamental Accounting Practice Exam

What method records income when earned and expenses when incurred?

1. Cash Basis Accounting

2. Accrual Basis of Accounting

3. Modified Cash Basis

4. Hybrid Accounting

The correct answer is: Accrual Basis of Accounting

The accrual basis of accounting is a method that recognizes income when it is earned and expenses when they are incurred, regardless of when the cash transactions occur. This approach aligns with the realization principle and the matching principle, both of which are fundamental to generally accepted accounting principles (GAAP). Under accrual accounting, revenue is recorded when a business delivers goods or services, reflecting the true financial position and performance of the company during a specific period. Similarly, expenses are recorded when the obligation to pay arises, which may occur before or after cash is exchanged. This method provides a more accurate picture of a company’s financial health, as it accounts for all resources that are generated and used in operations, thus allowing for better financial planning and analysis. In contrast to this method, other alternatives like cash basis accounting recognize income and expenses only when cash is received or paid, which may lead to distortions in financial reporting, particularly in businesses that have fluctuating cash flows. Modified cash basis and hybrid accounting combine elements of both accrual and cash basis, but do not fully adhere to the approach of recording income and expenses based on their earning and incurring, respectively.