Question

In Unit 3 we learn about recognition of revenue and expenses, and the proper timing of their recording in the firm's accounting records.

For those of us accustomed to thinking of revenue and expense occurring at the time payments are made and money changes hands, this may be a new and unfamiliar concept - but it is an important one.

Discuss the difference between accrual basis accounting and cash basis accounting. Please remember to create your submission in your own words. Feel free to include brief quotes from your sources (with citations) but do not copy and paste from the source material.

Answer 1

Accrual Basis of Accounting:

Accrual basis of accounting refers to when revenue is recognized when it is earned and expenses are recorded when they are incurred and not when cash is received/paid. Let's understand this in 2 parts. Revenue is recognized when it is earned means that revenue will be recognized once services/goods have been delivered to the customer and not when the cash is received from the customer. Similarly expenses will be recorded when the service/goods have been taken and not when cash is paid for the same. This is generally followed and preferred basis of accounting since it shows a true and fair picture of the accounts. For example under cash basis of accounting company might be showing a highly positive cash flow whereas it might have many accounts payable outstanding as at balance sheet date. One drawback of this basis is that it is more complex than cash basis of accounting.

Cash Basis of Accounting:

Cash basis of accounting refers to when revenue is recognized when cash is received and expenses are recorded when cash has been paid irrespective of whether revenue has been earned or expenses have been incurred. Hence in this case even if services/goods have not been delivered but cash has been received revenue will be recognized and similarly even if service/goods have not been taken, expenses will still be recorded if cash has been paid for the same. This is the most simple basis of accounting and is generally followed by small businesses only. Concepts such as unearned or unbilled revenue, provisions etc. do not exist in this basis of accounting.