The cash basis of accounting and the accrual basis of accounting are the two ways in which the
transactions of a business can be recorded. This paper will highlight the relative merits and demerits of
each of the above bases of accounting. Later on, we will delve into the mechanics of recording business
transactions in each of the above methods. This paper shall also explore the effects of each of the bases on
the taxation matters of the business. It will also describe the business circumstances in which one method
is to be preferred over other.
CASH BASIS OF ACCOUNTING
Cash basis of accounting is a method of accounting in which transactions are recorded in the books of accounts
when cash is actually received or paid out and not when the transactions take place. Therefore, it is the
recording of cash and bank transactions without taking account of fixed assets, debtors, creditors, inventories,
accruals, and the like.
It recognizes only transactions involving actual cash receipts and disbursements occuring in a given accounting
period. No attempt is made to record prepayments or accruals, that is, amounts owed to or by the business unit.
Cash basis of accounting cannot be used as an accounting model that attempts to produce a profit and loss
account and a balance sheet. Thus, net profit under this method represents simply the difference between cash
receipts and cash payments.
Cash basis of accounting is widely used by professionals and other service enterprises (e.g. physicians, lawyers,
etc.) in determining net income. Under this method, an income is not considered to be earned until payment is
received. Likewise, it is not necessary to accrue expenses incurred but not paid within the accounting period.
Inventories are recorded as a reduction in profit when they are paid for rather than when they are sold. But it is
not desirable to treat the entire cost of long-lived assets as an expense of the accounting period in which the
cash payment is made. Under a modified cash basis accounting, fixed assets are capitalized and the purchase of
a fixed asset is recorded as an asset. It is necessary to spread its cost over the periods in which it works and
must, therefore, be deducted from incomes as an expense in each of these periods.
According to cash basis of accounting, recognition of revenue is not always contingent upon the actual receipt
of cash. In some cases, income is said to be constructively received at the time it becomes available to the
business unit, regardless of when it is converted into cash. For example, a check is received immediately before
the close of the accounting year and it is converted into cash in the next year accounting period.
In a nutshell, under the cash basis accounting, revenues and expenses are recognized as follows: