In financial reporting, why is accrual accounting preferred over cash basis accounting?

Introduction / Context:
One of the most fundamental choices in accounting is between the accrual basis and the cash basis of accounting. Most large businesses and all listed companies are required to use accrual accounting for external financial reporting. This question tests whether you understand the main reason accrual accounting is preferred and how it provides better information to users than a simple cash basis.

Given Data / Assumptions:

• Accrual accounting recognises revenues when they are earned and expenses when they are incurred, not necessarily when cash is received or paid.
• Cash basis accounting recognises revenues and expenses only when cash actually changes hands.
• Users of financial statements care about profitability, performance trends, and the ability to generate future cash flows.
• The question asks for the main reason accrual accounting is used, not for a list of incorrect statements.

Concept / Approach:
Accrual accounting matches revenues with the expenses incurred to generate them, in the same reporting period. This matching principle and the recognition of income when it is earned (and of expenses when they are incurred) mean that the income statement under accrual accounting reflects the underlying economic performance of the business, independent of cash timing. By showing receivables, payables, and other accruals, the financial statements help users assess how current performance is likely to translate into future cash flows. In contrast, cash basis accounting can distort performance when cash receipts and payments are irregular or delayed.

Step-by-Step Solution:
Step 1: Recall that accrual accounting recognises revenue when earned and expenses when incurred, regardless of cash movements. Step 2: Understand that this approach gives a more accurate measure of profit or loss for each period because it matches income with related costs. Step 3: Recognise that investors and creditors are interested in the company's ability to generate future cash flows, which is better predicted by accrual-based performance measures than by raw cash receipts and payments. Step 4: Evaluate the options: option a states that accrual accounting provides a better indication of ability to generate cash flows; option b incorrectly describes cash basis rules; option c wrongly suggests that cash flows are unimportant. Step 5: Since only option a is consistent with standard accounting theory, it is the correct answer.

Verification / Alternative check:
Imagine a company that completes a large project in December but receives payment in January. Under cash basis accounting, no revenue would be recognised in December, and all revenue would appear next year, making the December performance look poor. Under accrual accounting, the revenue is recognised in December when the work is performed, with a receivable created. This gives a truer picture of performance and helps users predict upcoming cash collections. Similar logic applies to expenses, such as electricity or wages, which may be incurred before payment. This example confirms why accrual accounting gives better information about performance and future cash flows.

Why Other Options Are Wrong:
Option b actually describes cash basis accounting, not accrual accounting, and therefore cannot be a reason to prefer accrual accounting. Option c is incorrect because cash flows are very important; accrual accounting is used precisely because it helps predict future cash flows, not because cash flows are ignored. Option d (all of the above) cannot be correct because options b and c are wrong.

Common Pitfalls:
Students sometimes confuse the timing of revenue recognition under accrual and cash basis, thinking that accrual always means earlier recognition. In some cases, accrual may delay recognition until the earning process is complete. Another common mistake is to think that accrual accounting hides cash flows. In reality, good financial reporting provides both accrual-based profit measures and a separate cash flow statement, giving a full picture. Always remember that the main advantage of accrual accounting is better matching and better prediction of future cash flows.

Final Answer:
Accrual accounting is used because it provides a better indication of a company's ability to generate cash flows than the cash basis.