There are two bases of accounting from the point of view of the timing of recognition of revenue and expense for calculating the profit from the business activities at the end of a given period.
- Cash Basis of Accounting
- Accrual Basis of Accounting
They measure the operating performance of the business during the accounting period.
1. Cash Basis of Accounting
The cash basis of accounting is the practice of accounting for revenues in the period in which cash is received and for expenses in the period in which cash is paid.
Under the cash basis, You make entries for transactions in the book of accounts when you receive or pay cash and not when the receipt or payment becomes due.
In other words, Credit transactions are not considered at all including adjustments for outstanding expenses and accrued income items.
If office rent for the month of May 2019, is paid in July 2019, it would be recorded in the book of account only in July 2019.
Sale of goods on credit in the month of January 2019 would not be recorded in January but say in April, when the payment for the same is received.
As a basis for measuring performance for a particular accounting period, the cash basis of accounting does not adequately match the cost of the efforts required to generate inflows with the inflows themselves. Cash outflows of one period can relate to operating activities whose cash inflows occur in preceding or succeeding periods.
Thus this system is incompatible with the matching principle, which states that the revenue of a period is matched with the cost of the same period.
This method is useful for professional people like doctors, engineers, advocates, chartered accountants, brokers and small traders.
It is simple to adopt because there are no adjustment entries.
But this basis does not disclose the true profits because it does not consider the income and expense items that relate to the accounting period but not paid in cash.
2. Accrual Basis of Accounting
In the accrual accounting, revenues and expenses are recorded when they are earned or incurred rather than when they are received or paid.
Under this accounting method, You make entries for transactions in the book of accounts when the receipt or payment becomes due.
In simple words, expenses are recorded as when the liability to pay arise. Revenue is recorded as when the right to receive is established
Thus, under this system, the monitory effect of a transaction is taken into account in the period in which they are earned rather than in the period in which cash is actually received or paid by the enterprise.
The accrual basis of accounting provides a better measure of operating performance than the cash basis of accounting because the revenue of a period is matched with the cost of the same period.
The accrual basis of accounting is also called the mercantile system of accounting.
The advantages of this system are:
- It is based on all business transaction of the year and, therefore, discloses the current profit or loss;
- The method is used in all types of business units;
- It is more scientific and rational application;
- It is most suitable for the application of the matching principle.
The disadvantages are:
- It is not a simple one and requires the use of estimates and personal judgment;
- It fails to disclose the actual cash flows
Difference between Cash and Accrual Basis
|Cash Basis||Accrual Basis|
Using the cash-basis, revenue is only recorded when the cash is actually received
Under Accrual basis, revenue is recorded when it’s earned.
In cash accounting, expense is only recorded when the cash is actually paid.
In accrual accounting, exepense is recorded when it becomes due.
The cash-basis is quite simple to understand and maintain.
The accrual basis is more complicated to understand and maintain.
The cash basis is incompatible with the matching principle.
The accrual accounting method properly applies the matching principle.