Under GAAP, which accounting method is required and why?

• A. Accrual basis recognizes revenues when cash is received and expenses when paid; GAAP requires accrual to reflect economic substance.
• B. Cash basis recognizes revenue and expenses when earned; GAAP does not require accrual.
• C. Accrual basis recognizes revenue and expenses when earned or incurred; GAAP requires accrual to reflect economic substance and faithful representation.
• D. Hybrid basis recognizes revenue when earned and expenses when paid; GAAP requires this hybrid.

Answer: (C)

Accrual accounting is required under GAAP because it records what a company has actually earned or incurred, not just when cash moves. Revenue is recognized when it is earned—when the goods or services are delivered and collectability is reasonably assured—and expenses are recognized when they are incurred in generating those revenues. This matching of revenues and the associated costs provides a more accurate picture of a period’s performance and financial position, which is essential for faithful representation. Cash basis would delay or advance recognition based on cash flows rather than the underlying economic events, leading to distorted timing. A hybrid approach mixes methods in a way GAAP does not permit. So the accrual basis, recognizing revenue when earned and expenses when incurred, best aligns with GAAP’s objectives.