United International University

Course Name: Financial Accounting

Course Code: ACC 502
Assignment Topic:
“Explain Accrual Basis of accounting vs Cash Basis of Accounting with examples.
Which Basis is prescribed by GAAP and why”

Submitted To: Submitted By:

Dr. Salma Karim Maliha Mahzabin
Professor ID: 112 213 005
School of Business and Economics Program: MBA
(SOBE)

Date of Submission: December 11, 2021

Explain Accrual Basis of accounting vs Cash Basis of Accounting
with example. Which Basis is prescribed by GAAP and why?
Definition:

Accrual basis accounting means revenue and expenses are recognized and recorded when they
occur, while cash basis accounting means these line items aren't documented until cash
exchanges hands. Cash basis accounting is easier, but accrual accounting portrays a more
accurate portrait of a company's health by including accounts payable and accounts receivable.

Advantages:

The key advantage of the cash method is its simplicity, it only accounts for cash paid or received.
Tracking the cash flow of a company is also easier with the cash method. Meanwhile, the
advantage of the accrual method is that it includes accounts receivables and payables and, as a
result, is a more accurate picture of the profitability of a company, particularly in the long term.

Disadvantages:

Disadvantage of the cash method is that it might overstate the health of a company that is cash-
rich but has large sums of accounts payables that far exceed the cash on the books and the
company's current revenue stream. The disadvantage of the accrual method is that it doesn't track
cash flow and, as a result, might not account for a company with a major cash shortage in the
short term, despite looking profitable in the long term.

Timing Issues:

The biggest difference between cash and accrual basis accounting is the timing issues of when
transactions are recognized and recorded. Under accrual accounting, the revenue is recognized
when the service is delivered. Cash accounting basis is not able to show the future amounts of
revenue and liabilities which makes this method less preferable by the GAAP because it’s not as
accurate at the accrual accounting method.

Nature:

Cash basis is simple in nature but Accrual basis is complex in nature.

Accounting system followed:

Cash basis of accounting follows the single entry system that records either inflow or outflow of
cash and accrual basis accounting follows a double entry system of accounting where each
transaction has two outcomes in the form of debit and credit.

Variations in Income Statement:

Income statement will show a relatively lower income under cash basis of accounting but Income
statement will show higher income levels under the accrual basis of accounting.

Accuracy:

Cash basis of accounting has low accuracy. Accrual basis of accounting is more accurate than the
cash basis of accounting.

Auditing of Financial Statements:

Under cash basis of accounting financial statements cannot be audited. Financial statements can
be audited only when they are prepared using accrual basis of accounting.

Suitable for:

Cash basis of accounting is suitable for micro to small businesses. Accrual basis of accounting is
suitable for large corporations.

Examples:

I. Revenue recognition: A company sells $10,000 of green widgets 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.
II. Expense recognition: A company buys $500 of office supplies in May, which it pays for
in June. Under the cash basis, the buyer recognizes the purchase in June, when it pays the
bill. Under the accrual basis, the buyer recognizes the purchase in May, when it receives
the supplier's invoice.
The cash basis of accounting recognizes revenues when cash is received and recognizes expenses
when cash is paid out. Under the cash basis, the revenue would not be reported in the year the
work was done but in the following year when the cash is actually received.

Because the cash basis of accounting does not match expenses incurred and revenues earned in
the appropriate year, it does not follow Generally Accepted Accounting Principles (GAAP).
Companies using the cash basis do not have to prepare any adjusting entries unless they discover
they have made a mistake in preparing an entry during the accounting period. By following
GAAP’s suggestion, most companies use the accrual basis of accounting because it recognizes
revenues when earned (a product is sold or a service has been performed), regardless of when
cash is received. Expenses are recognized as incurred, whether or not cash has been paid out.

For instance, assume a company performs services for a customer on account. Although the
company has received no cash, the revenue is recorded at the time the company performs the
service. Later, when the company receives the cash, no revenue is recorded because the company
has already recorded the revenue. Under the accrual basis, adjusting entries are needed to bring
the accounts up to date for unrecorded economic activity that has taken place.