Financial accounting is a major source of information for success of business. Most important aspect of financial accounting system is referred to as recognition, it’s the decision about when to record revenue and expense transactions. We have two type of accounting used to record transactions, cash and accrual.
In this article, we will be discussing both cash and accrual basis of accounting to understand which one is better
Cash basis of accounting
In cash basis of accounting, revenue and expenses are recognized with the receipt and payment of cash. This means, you have to record revenue when the money is received from customers and expenses are booked when money has been paid or when cheques are written for payments. This means, transactions are not recorded unless money paid or received for it
In this type of cases, receipts and payments account is prepared based on cash book and bank statements.
The problem with cash basis is that it does not recognize credit transactions such as liabilities, selling goods to customers on credit, purchasing raw materials from vendors on credit and expenses that are incurred.
This means, transactions will be recorded only when you pay to your vendor or receive money from customers. In simplified terms, it doesn’t record anything until actual money has traded hands.
Due to this reason, cash basis does not provide accurate picture of the financial statements.
Its used by very small organizations which does not have credit transactions such as schools, colleges and certain government departments.
To get accurate view of your financial statements, we suggest you to use accrual based accounting. Now a day, all companies small or big are using accrual basis.
Under the accrual basis of accounting, revenue is recognized only when goods or services have been delivered or provided regardless of when money is collected. Similarly, expenses are recognized only when its incurred regardless when money is paid out. This system follows the matching concept.
Matching revenues with the expenses incurred for producing those revenues, will give a clearer picture of the actual profit of the company.
Accrual basis is much more accurate compare to cash basis. At the end of the year, to get more accurate picture, the accounts are adjusted to reflect the revenue earned and costs incurred to earn it.