ACCOUNTING METHODS (CASH BASIS AND ACCRUAL BASIS OF ACCOUNTING)

EXAMPLE:
A business occupies premises at an annual rental of $2 000. In one year it has
paid one quarter’s rent in advance. It has also used $2 100 worth of electricity
but it has paid only $1 200 because it has not paid the latest bill for $900. Its
gross profit for the year is $10 000.
Income Statements prepared on (a) cash basis and (b) on an accruals basis
(matching) would look as follows:
(a) Cash Basis (b)Accrual Basis
$ $ $ $
Gross profit 10 000 10 000
Less: Rent 2 500 2 000
Electricity 1 200 3 700 2 100 4 100
Net income 6 300 5 900

The accruals basis is the correct one as it records the actual costs incurred in the
period for rent and electricity.

The Income Statement should be prepared on the accruals or matching basis so

that expenses are matched to revenue earned; that is, expenses should be
shown in the Income Statement as they have been incurred rather than as they
have been paid.

EXERCISES:
MAY/JUNE 2018:
1. (b) (i) Distinguish between ‘accrual basis accounting’ and ‘cash basis
accounting’. (4 marks)
(ii) Identify TWO reasons why an organization would use ‘accrual
basis accounting’ instead of ‘cash basis accounting’. (2 marks)
MAY/JUNE 2021:
1. (a) The objectives of financial statements is to provide information about
the financial position, performance and changes in financial position of an
 enterprise. This information is useful to a wide range of users in making
economic decisions.
(i) List FOUR main users of financial statements. (4 marks)
(ii) State ONE purpose of financial statements for EACH of the users
listed in (a) (i). (4 marks)
MULTIPLE-CHOICE ITEMS:
1. One of the MAIN purpose of financial accounting is to
A. Ensure that current assets can cover all expenses
B. Account for all non-monetary items in financial statements
C. Monitor the functions of the board of directors of a company
D. Provide useful information for planning and decision-making

2. One MAJOR disadvantage of traditional financial statements is their

emphasis on
A. Relevance
B. Historical cost
C. Long-term growth
D. Short-term profitability
Item 3 refers to the following statement.
“One limitation of financial information is the use of estimates in the financial
statements.”
3. Which of the following show evidence of such estimates?
I. Machinery to be depreciated by 20% on cost.
II. Corporation tax is to be 30% of net income.
III. Allowance for doubtful debt to be 5% of net sales.
A. I and II only
B. I and III only
C. II and III only
D. I, II and III
Item 4 refers to the following information from the books of Orange Vale Inc.
for the year ending 30 June 2020.
$
 Receipts from sales 286 120
Payments made to suppliers for goods 103 404
Payments made for operating expenses 23 615
Accrued operating expenses 7 218
Depreciation expense 12 007

4. The net income for the year, using the cash basis of accounting, is
A. $150 683
B. $151 883
C. $159 101
D. $254 087

5. On 15 January 2020, B. James’ advertising agency collected $6 000 from

clients who were billed for jobs done in December 2019. Using the
accrual basis of accounting, how should the accounts be affected by the
transactions on 15 January 2020?
A. Increase: Cash Increase: Service revenue
B. Increase: Cash Decrease: Accounts receivable
C. Increase: Service revenue Decrease: Fees earned
D. Increase: Cash Increase: Accounts receivable