d Explain what is meant by the accrual basis of accounting a

d) Explain what is meant by the accrual basis of accounting and how it differs from the cash basis of accounting. Provide an example to illustrate the difference. Describe which financial statements are prepared using the accrual basis of accounting and which using the cash basis. 6 marks

Solution

Differences between cash system and accrual system of accounting are described as follows:-

1. Under cash system of accounting revenue and expenses are recognized when amount is actually paid or received in cash

2. Compliance with generally accepted accounting principle is must in accrual system of accounting whereas no such compliance is required under cash system

3. Revenues and expenses are recorded under accrual system when services are rendered and amount is actually earned no matter whether cash is received or not. The same way expenses are reported in the period when they occur and not when amount is paid in cash.

4. Accrual system provides a better picture of company’s profits as transactions are recorded when they are earned but under cash system completion of transaction is not necessary and therefore recording on the basis of cash received or paid is not correct

5. Cash method is simple and easy to use whereas accrual method is comparatively complex

6. Cash basis of accounting is best suitable for small businessman who lack much knowledge of accounting as maintaining and recording financial information is bit easier .The size of a company makes difference. The cash basis of accounting is useful in small concerns whereas accrual basis of accounting is useful in large concerns.

Example; A company sells $10,000 of inventory to a customer in March, which pays the invoice in April. Under the cash basis, the seller recognizes the sale in April, when the cash is received. Under the accrual basis, the seller recognizes the sale in March, when it issues the invoice.

In cash basis accounting, the matching concept is not followed because it records the expenses when it has been actually paid in cash and in the same way it records the revenue when it actually received whether it is received in cash or in any other form. In accrual basis accounting, the matching concept is followed because it records the revenue when the work has been done or the service has been provided whether the amount received in cash or not. The company which has inventory should select accrual basis of accounting because in accrual basis of accounting when the inventory is sold whether the cash is received or not it is recorded as revenue but is not so in cash basis accounting . It will record revenue when actually cash received.