Question

Discuss the cash basis of accounting versus the accrual basis of accounting. Include * examples and references to any relevant principles. (3 marks)

Answer 1

Let us first take up a situation / example

Assume you have a business and you want to see how much your business made over the past few years.
If you would have kept your records on CASH basis, you'd have recorded incomes and expenses at the time of ACTUAL CASH RECEIPT / PAYMENT. If in one year there was no receipt from customers, the business would have shown losses. Then in the next year, if the receipt for this year and the one for next year are received in the same year there would be huge profits.

See how unstable would these results be?

The cash basis of accounting recognises revenues when cash is received and expenses when they are paid. There would never be any payable or receivable in this case.

On the other hand, accrual basis of accounting results in recording of expenses when they are incurred and revenues when they are earned. When the actual cash is received or paid is irrelevant in this case. Accrual basis gives a more realistic and balanced result.

Accrual basis is the best method to ensure MATCHING PRINCIPLE is followed.

Cash accounting	Accrual accounting
It recognizes revenue when the cash is received	It recognizes revenue when it is earned.
It recognized expenses when it is paid	It recognized expenses when it is billed
Taxes are paid only on cash	Taxes are paid on money owed as well
It is mostly used small businesses and sole proprietors.	It is used when the size is big