In terms of recording revenues and expenses, there are two methods of accounting namely, cash basis of accounting and accrual basis of accounting. Most of the modern-day accounting is based on accrual concept as GAAP and IFRS also require entities to follow accrual basis of accounting.
So what is accrual concept of accounting? As per accrual concept:
- revenues are recorded when earned regardless of whether cash is received or not; and
- expenses are recorded when incurred regardless of whether cash is paid or not.
Alternatively, in cash basis of accounting, revenues are recorded when cash is received and expenses are recorded when cash is paid. Apparently, cash basis of accounting is relatively simpler of the two methods, as in accrual method, certain management estimates are required and usually adjusting entries are also required at the end of an accounting period. Then why has the modern-day accounting shifted to accrual based accounting? What is the reason that most accounting standards require that accrual based accounting must be followed? Here are some very important advantages of accrual based accounting which has led to enormous acceptance of this method.
- Income, expenses, assets and liabilities reported in this method are more accurate.
- Revenues and expenses are recorded in the relevant period to which they are related.
- Effective profitability and financial performance analysis is possible in this method as the revenues and expenses are representative of actual performance during a period.
- Recording revenues on accrual leads to recording accounts receivable, which helps the management to track the receivables and to effectively follow-up the debtors.
- Recording expenses on accrual leads to recording accounts payable, which gives the management more control over its liabilities so that they are paid before due dates to avoid late payment penalties.
Let’s take a look at the following example to further elaborate the difference in accrual basis of accounting and cash basis of accounting.
Example – Accrual basis vs Cash basis
Following are some business transactions of a small company Innovative ITech Inc., which is involved in providing website development and support services to its customers.
- On 1 January 20×0, the company paid two years advance rent for its office amounting to $24,000.
- On 5 January 20×0, the company got a project for development of a website for $20,000. Further, a maintenance agreement was also made according to which the company was supposed to provide website maintenance and support services to its customer for a period of 1.5 years after the website is completed. Maintenance agreement was for $30,000 which will be paid at the end of the maintenance period.
- A consultant was hired who was given this job of developing the website and providing maintenance services. It was agreed with the consultant that he will be paid $3,000 semi-annually, five days after the end of each six months.
- On 30 June 20×0, the company completed the development of website and received $20,000 from its customer.
- On 31 December 20×1, maintenance period was completed and the company received $30,000 from its customer.
Now let’s record the above transaction via journal entries as per both methods of accounting.
Journal entries – Cash basis of accounting
Financial year 20×0
| Date | Accounts | Debit | Credit |
| 1 Jan 20×0 | Rent expense | 24,000 | |
| Cash | 24,000 | ||
| 30 Jun 20×0 | Cash | 20,000 | |
| Revenue | 20,000 | ||
| 5 Jul 20×0 | Consultancy expense | 3,000 | |
| Cash | 3,000 |
Financial year 20×1
| Date | Accounts | Debit | Credit |
| 5 Jan 20×1 | Consultancy expense | 3,000 | |
| Cash | 3,000 | ||
| 5 Jul 20×1 | Consultancy expense | 3,000 | |
| Cash | 3,000 | ||
| 31 Dec 20×1 | Cash | 30,000 | |
| Revenue | 30,000 |
Journal entries – Accrual basis of accounting
Financial year 20×0
| Date | Accounts | Debit | Credit |
| 1 Jan 20×0 | Prepaid rent | 24,000 | |
| Cash | 24,000 | ||
| 30 Jun 20×0 | Cash | 20,000 | |
| Revenue | 20,000 | ||
| 5 Jul 20×0 | Consultancy expense | 3,000 | |
| Cash | 3,000 | ||
| 31 Dec 20×0 | Accounts receivable | 10,000 | |
| Maintenance services revenue | 10,000 | ||
| 31 Dec 20×0 | Rent expense | 12,000 | |
| Prepaid rent | 12,000 | ||
| 31 Dec 20×0 | Consultancy expense | 3,000 | |
| Accounts payable | 3,000 |
Financial year 20×1
| Date | Accounts | Debit | Credit |
| 5 Jan 20×1 | Accounts payable | 3,000 | |
| Cash | 3,000 | ||
| 5 Jul 20×1 | Consultancy expense | 3,000 | |
| Cash | 3,000 | ||
| 31 Dec 20×1 | Rent expense | 12,000 | |
| Prepaid rent | 12,000 | ||
| 31 Dec 20×1 | Consultancy expense | 3,000 | |
| Accounts payable | 3,000 | ||
| 31 Dec 20×1 | Cash | 30,000 | |
| Accounts receivable | 10,000 | ||
| Maintenance services revenue | 20,000 |
Now let’s take a look at the income statements of both years under both methods of accounting in order to evaluate the accuracy of reporting under both methods.
From the above income statements, we can clearly see some of the drawbacks of using cash basis of accounting. For instance, office rent expense of two years is recorded when it is paid as a result of which there is an overstatement of office rent expense in first year, whereas there is no office rent expense in second year. Similarly, maintenance services for six months have been provided by the company in the first year, but no revenue is recorded to represent that service and all the services revenue is recorded in the second year when it is received. Another drawback is that matching principle is also not complied with under cash basis of accounting. By the end of second year, the project is completed and all revenue is recorded, however, consultancy expense of $3,000 has not been recorded as it is not paid. All these drawbacks and inaccuracies in financial reporting are addressed in the income statement prepared on the basis of accrual concept.