Cash Basis of Accounting
Cash Basis of Accounting uses receipts and payments of cash to record incomes and expenses. Therefore, under the cash basis of accounting, if a corporation makes salary payments of January, 3 months later in April, it will be considered as expenses in the month of April, since that is when the cash was paid. Also, if the same company pays advance salary for the month of May in April, then it will be considered as an expense for April.
Similarly, the time companies spend doing value addition to their products, shows up in the books as expenses. Only when sale is closed and cash comes in the door, is income recognized. Cash basis of accounting considers advance payments as income since the cash has been received.
There are obvious problems with cash basis of accounting. They are as follows:
Expenses Tend to be Cluttered: It is not uncommon for firms to negotiate trade credit for themselves. Under the terms of trade credit, firms use raw materials over a period of time and then make one lump sum payment for the use. Under the cash basis of accounting, all expenses appear on the financial statements at one go when the payment is made. This clutters expenses on the financial statements.
Income Tends to be Cluttered: Just like we use credit from our suppliers, the firms that deal with us also tend to use our credit. They also make our payments in one lump sum. Therefore just like the expenses, the income also tends to be cluttered.
Financials Become Unpredictable: Under the cash basis of accounting, there will be no or very little income and expenses in some months and very large income and expenses in some others. This will be because of the cluttering effect. As a result, the financials become unpredictable.
Accrual Basis of Accounting
On the other hand, accrual basis of accounting, recognized income when it is earned and recognizes expenses when they are incurred:
The firm will expense raw materials consistently as they are used and not in one single charge when they are paid for.
The firm will record income when all responsibilities pertaining to the sale have been fulfilled and the firm has a right to claim money from the customers.
Advance cash received will be treated as a liability. The firm will either have to return the cash back or provide services in lieu of the same.
We use a combination of cash and accrual basis of accounting. The profit and loss account and balance sheet are prepared as per accrual basis while the cash flow statement tells about the cash situation of the firm.