Business transactions are documented in the books of account according to one of three accounting bases: (i) Cash Basis of Accounting; (ii) Accrual Basis of Accounting; or (iii) Hybrid Basis of Accounting. Despite the fact that the accrual basis is the most fundamental accounting concept, the cash basis is also used, though in a restricted way. Professionals and non-trading organizations like clubs, schools, and hospitals, for example, employ the cash basis of accounting. The three methods to accounting, namely Cash Basis of Accounting, Accrual Basis of Accounting, and Hybrid Basis of Accounting, will be discussed in detail to show how and when income and expenses are recognized.
Cash Basis of Accounting
The cash basis of accounting is a method of accounting in which transactions are recorded in the books of account when cash is received and paid. Credit transactions, such as credit purchases and sales, are not recorded in the books of account under this method. When cash is paid or received, they are documented in the books of account. When cash is received, revenue is recognized using the Cash Basis of Accounting. Goods sold on credit, for example, will not be recorded until the sale proceeds are received. Accrued income and income received in advance are not calculated and recorded since revenue is recognized on a cash basis.
Expenses, on the other hand, are only recorded as incurred once they have been paid. If a salary is paid in April for the month of March, for example, it will be recorded in April. Outstanding and prepaid expenditures are not evaluated and recognised since the transaction is recorded when cash is exchanged. The profit or loss of an enterprise for a certain accounting period is the difference between cash revenues and cash payments. The Receipts and Payments Account, which is created for non-trading organizations such as charity institutions, clubs, and schools, is an example of cash-basis accounting.
Advantages of Cash Basis of Accounting
- It is easy since adjustment entries are not required.
- This method is more objective since it requires fewer estimations and judgments.
- This accounting method is appropriate for businesses when the majority of transactions are handled in cash.
Disadvantages of Cash Basis of Accounting
- It fails to provide an accurate and fair picture of an enterprise’s profit or loss and financial condition because it overlooks a basic accounting assumption, namely, the Accrual Assumption. As a result, accruing earnings and incomes received in advance, as well as ongoing and prepaid costs, are not accounted for.
- It does not adhere to the Matching Principle of accounting.
- Since this approach does not differentiate between capital and revenue items, the profits of the two years are inconsistent.
- Actual cash inflows and outflows are taken into account under this accounting method. Profit manipulation is a possibility. Payments, for example, may be delayed or postponed, and income may be delayed or received early.
Accrual Basis of Accounting
According to the accrual basis of accounting revenue and costs are recorded in the period in which they become due, rather than when they are received or paid, Credit sales, for example, are included in total sales for the period, regardless as to whether money is received or not. Similarly, if a company uses a service but does not pay for it, the expenditure is recorded in the books in the year in which the service is used, not in the year in which the payment is made.
Advantages of Accrual Basis of Accounting
- This system discloses proper profit or loss for a given period as well as the actual financial situation of the firm, since it takes into account all transactions relevant to the period adjusted for outstanding costs, prepaid expenses, accrued earnings, and incomes received in advance.
- It accurately reflects profit or loss throughout the accounting period and, as a result, it is widely accepted. Almost every commercial institution follows this system.
Disadvantages of Accrual Basis of Accounting
- The accounting procedure is very lengthy and complex under this basis.
- A rapid assessment of profit/loss is impossible due to the numerous adjustments that are necessary to identify the real financial performance of the firm, such as outstanding costs, prepaid expenses, accumulated revenue, money received in advance, and so on.
Difference between Accrual and Cash Basis of Accounting
Basis of Difference
1.Outstanding Expenses or Income
In the Balance Sheet, there may be prepaid or outstanding costs, as well as accrued and unearned revenues.
There are no prepaid or outstanding costs, nor accrued or unearned incomes under this method
2. Variations in Income In case of accrued income.
Due to the recording of accrued incomes, the income statement will reflect a considerably greater income.
Under this basis, the income statement will reflect a lesser income.
3. Variations of income in case
of outstanding expenses
Due to the recording of outstanding expenses, the income Statement will show a
relatively lower income.
Under this basis, an income Statement will reflect a higher income.
Hybrid Basis of Accounting
It is a mix of the Cash Basis and the Accrual Basis of Accounting. Revenues are accounted for on a Cash Basis, while costs are accounted for on an Accrual Basis, under the Hybrid Basis of Accounting (also known as Mixed System of Accounting). In practice, this method of accounting is not employed since it fails to appropriately assess income. Furthermore, no authority, including tax authorities, accepts the hybrid basis of accounting.
Accounting can be done on various basis the two most important of them are cash basis and accrual basis. A business can either choose cash basis or accrual basis but not both. Both of them offer various advantages and also have certain disadvantages. A business should consider its requirements and decide which basis suits them the best for their accounting process.