Financial accounting involves measuring, presenting and reporting of financial transactions of an enterprise. The transactions are recorded in the books of accounts of the enterprise from which financial statements are subsequently drawn up. The recording of transactions in the books of accounts require adherence to certain accounting principles. There are broadly two methods of financial accounting that can be followed – accrual basis and cash basis.
This article looks at the meaning of and differences between these two methods more closely.
Definitions and meanings
Accrual basis of accounting:
Accrual basis of accounting (also known as mercantile basis of accounting) records transactions as and when they are incurred. Incomes are recognized when they are due and expenses are reported when they accrue, irrespective of actual exchange of cash at the time of recognition/accrual.
Accrual basis of accounting is required to adhere to prescribed accounting standards and principles.
This method of accounting results in creation of assets i.e., receivables and liabilities i.e., payables, in the books of accounts. These assets and liabilities are nullified when actual settlement takes place.
This method of accounting requires reference to agreements and commitments to determine when incomes are due or when expenses accrue. For example, interest expenses should be recorded in accordance with the terms of the loan agreement irrespective of whether it is actually paid off at that time or not.
Accrual basis of accounting gives a more reliable presentation of financial condition of the enterprise. It is for this reason that majority of the countries mandate following accrual basis of accounting by enterprises for reporting purposes.
Cash basis of accounting:
Cash basis of accounting involves recording of transactions only when there is actual inflow or outflow of cash/money. Incomes are recorded when they are monetarily received and expenses are reported when they are actually paid for.
Application of cash basis of accounting requires minimal accounting knowledge.
Application of cash basis of accounting is not permitted under local Generally Accepted Accounting Principles (GAAPs) or under International Financial Reporting Standards (IFRSs).
Cash basis of accounting is generally opted for by smaller enterprises such as sole proprietors or small firms, who wish to maintain minimum accounting records and do not require to publicly report their financial statements.
Difference between accrual basis and cash basis of accounting:
The difference between accrual basis and cash basis of accounting has been detailed below:
1. Meanings
- Accrual basis of accounting accounts for transactions as and when they are incurred.
- Cash basis of accounting accounts for transactions only when there is actual inflow or outflow of cash/money
2. Treatment to incomes and expenses
- In accrual accounting, incomes are recognized when they are due and expenses are recorded when they accrue.
- In cash accounting, incomes are recognized when they are actually received and expenses are recorded when they are actually paid for.
3. Sequence and quantum of entries
- In accrual accounting, every transaction has a minimum of 2 accounting entries, with the accrual entry first and the settlement entry at a subsequent date.
- In cash basis of accounting, each transaction is generally recorded through one accounting entry.
4. Complexity
- Accrual accounting is more complex.
- Cash basis accounting is simpler than accrual accounting.
5. Reflection of financial condition
- Accrual basis gives a more reliable and fair view of the financial condition as it accounts for all transactions when they accrue. Financial statements drawn up through this system of accounting can be used to analyse profitability.
- Cash basis gives a less reliable view as it accounts for only cash settled transactions. Financial statements drawn up through this system cannot be used to accurately assess and analyse profitability.
6. Statutory recognition
- Accrual basis is recognized by generally accepted accounting principles (GAAPs) and internal financial reporting standards (IFRSs).
- Cash basis is not recognized by generally accepted accounting principles (GAAPs) and internal financial reporting standards (IFRSs).
7. Preferred by
- Accrual basis is opted for by enterprises that rely on the financial statements to assess their profitability.
- Cash basis is preferred by smaller enterprises that wish to maintain minimum accounting records and do not require to publicly report their financial statements
Accrual basis versus cash basis accounting – tabular comparison
A tabular comparison of accrual basis and cash basis of accounting is given below:
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| Meaning | ||||
| Records transaction as and when they occur | Records only those transactions which involve inflow/outflow of cash | |||
| Treatment to incomes and expenses | ||||
| Incomes recognized when due and expenses recorded when they accrue | Incomes recognized when they are actually received and expenses when they are actually paid | |||
| Quantum of entries per transaction | ||||
| Multiple | Generally single | |||
| Complexity | ||||
| Complex | Simple | |||
| Reflection of financial condition | ||||
| Reliable view | Less reliable view | |||
| Statutory recognition by GAAPs and IFRSs | ||||
| Recognized | Not recognized | |||
| Preferred by | ||||
| Medium and large enterprises | Small enterprises such as sole proprietors | |||
Conclusion – accrual basis vs cash basis of accounting:
Both accrual basis accounting and cash basis accounting are branches of financial accounting. While cash basis accounting is simpler and can be applied without much accounting knowledge, it reflects only the cash flow position of the enterprise. Financial statements are generally drawn up to analyse profitability and for reporting purposes, cash basis accounting does not suffice in such cases and accrual basis accounting could be preferred here.
