The basis of accounting mostly refers to how accounting records are kept and maintained within the company. There are two main types of accounting that the company uses. They can either include cash basis of accounting or accrual basis of accounting.
Cash Basis of Accounting
Cash Basis of Accounting mostly recognizes revenues when cash is received, and the company pays expenses. This implies that accounting entries are only carried out when cash exchanges hand to the company. Therefore, under this method, accounts receivables or accounts payables are not recorded.
Small companies mostly use the cash method of accounting because of the relative ease with which records can be maintained using this particular basis of accounting. Cash basis only considers cash incoming as income and cash paid as expenses. There are no accruals, prepayments, or receivables involved in the cash basis of accounting.
The main distinguishing factor regarding the cash basis of accounting is when income and expenses are recognized. Since everything is recorded on a cash basis, sales are only meant to be conducted when payment for the goods has been received. In the same manner, expenses are only said to have been incurred when paying for these expenses has been recorded.
Example of Cash Basis of Accounting
The concept of cash basis of accounting is illustrated via the following example:
Hans and Co. have the following transactions for the month ended 31st December 2020:
- Sold goods worth $500 to Everton Ltd. The payment for these goods was deferred till January 2021.
- Sold goods on cash worth $2500 to Macy Co. The amount was settled in cash at the time of delivery of goods.
- Received payment worth $1500 from Primark Food for goods sold in November 2020.
- Utilities amounting to $700 were paid in the month of December 2020.
- Paid advance rent amounting to $1500 for the three months January 2021-March 2021.
Under the cash basis of accounting, it can be seen that the following entries will be recorded in the Income Statement for the month ended 31st December 2020:
| Sales Revenue | |
| – Macy Co. | $2500 |
| -Primark | $1500 |
| Expenses | |
| -Utilities | $700 |
| -Advance Rent | $1500 |
| Profit | $1800 |
Advantages of using Cash Basis of Accounting
The advantages of using the cash basis of accounting are as follows:
- It is easier to manage for smaller companies.
- The chance of error is relatively minimal.
- There is no need to maintain a separate cash flow statement.
Disadvantages of using Cash Basis of Accounting
The disadvantages of using the cash basis of accounting are as follows:
- Cash flows are not equivalent to profitability of the company. Therefore, it might not give a fair view regarding the actual financial position of the company.
- Cash basis of accounting does not incorporate Accounts Receivable or Accounts Payable. In case of credit based transactions, a separate record needs to be kept.
- Year-end reconciliations and self-audit might be challenging in case of cash basis of accounting.
Accrual Basis of Accounting
The Accrual Basis of Accounting is derived from the matching principle. Under this premise, the main rationale of accounting follows matching revenues and expenses over a certain year. This implies that all revenues that have been earned in a certain year should ideally be matched with expenses that have been incurred in the given year.
This helps companies get an idea of their profitability over time. This is resourceful, primarily because it depicts a better picture of the actual profitability, as well as performance of the company over a time period.
The only downside to the accrual basis of accounting is that it does not give any resourceful insights regarding the company’s actual cash position. Cash flows in themselves are significant for the company since they give an idea regarding the liquidity position of the company.
However, this particular issue can be dealt with by preparing a separate Cash Flow Statement that gives a proper idea regarding the company’s cash flow position.
The revenue recognition principle is used under the accrual basis of accounting, which divides the revenue into two broader categories: Earned Revenues and Unearned Revenues. Earned Revenues are defined as revenues that have already been serviced by the company (this implies that the goods or services against the particular order have been delivered).
Unearned revenues, on the other hand, are treated as current liabilities. They are recorded against payments that have been received against different orders, but the goods (or services) are yet to be provided by the company against this receipt.
Therefore, on an accrual basis, sales are recorded, irrespective of the timeline of payment. Once the organization delivers goods, it is regarded as a sale, even if it is unpaid.
The same protocol follows for expenses. Expenses are recorded when they are incurred. The point of recognition is the utilization of services. This, too, is irrespective of the cash payment paid or received against the amount.
Example of Accrual Basis of Accounting
The concept of cash basis of accounting is illustrated via the following example:
Hans and Co. have the following transactions for the month ended 31st December 2020:
- Sold goods worth $500 to Everton Ltd. The payment for these goods was deferred till January 2021.
- Sold goods on cash worth $2500 to Macy Co. The amount was settled in cash at the time of delivery of goods.
- Received payment worth $1500 from Primark Food for goods sold in November 2020.
- Utilities amounting to $700 were paid in the month of December 2020.
- Paid advance rent amounting to $1500 for the three months January 2021-March 2021.
Under the cash basis of accounting, it can be seen that the following entries will be recorded in the Income Statement for the month ended 31st December 2020:
| Sales Revenue | |
| – Everton | $500 |
| -Macy Co. | $2500 |
| Expenses | |
| Profit for the month of Everton | $3000 |
Advantages of using Cash Basis of Accounting
The advantages of using the cash basis of accounting are as follows:
- It gives a realistic view regarding the profitability of the company.
- Since it follows the matching principle, it comprises comparing expenses with revenues.
- It can be relied upon as a decision making tool, unlike statements prepared under cash basis of accounting.
Disadvantages of using Cash Basis of Accounting
The disadvantages of using the cash basis of accounting are as follows:
- Accrual basis of accounting might be harder to prepare for smaller firms.
- It does not give an idea regarding the liquidity position of the company, therefore, a separate cash flow statement needs to be prepared.
Comparison between Cash Basis of Accounting and Accrual Basis of Accounting
| Cash Basis of Accounting | Accrual Basis of Accounting |
| This particular basis of accounting recognizes revenues When the company has actually received cash. | Under the accrual basis of accounting, revenues are only recognized when they are earned. |
| Expenses are recognized when cash has been spent instead of expenses. | Expenses are recognized when they are actually incurred. The payment for these Expenses does not impact the recognition of these expenses. |
| This is mostly used by small businesses, which do not have proper accounting records in place. | This is used by companies that are larger in size and have proper accounting records in place. |
