Question

How does the accrual basis of accounting provide different results when compared with the cash basis? Which provides a better picture of a company’s performance? Why? Why does a company depreciate its long-term assets? Explain the process for recording depreciation when adjusting entries are recorded.

Answer 1

The accrual basis of accounting recognises incomes and expenses as and when earned and incurred respectively rather than when the cash is received and paid respectively in case of cash based accounting. For example, when goods are purchased on account, the accrual basis of accounting recognises the same as expense eventhough the actual cash outflow did not take place since the obligation to make payment (at a future date, if not now) has already been incurred by the company and the company have the responsibility to honour the payment rendering the expenditure to have already incurred. However the cash based accounting postpones the recognition of expenditure till the cash outflow actually occurs. The same holds good in case of incomes and any other financial item whcih is recorded in the income statement thereby resulting in differences in the results obtained by deploying both the bases for accounting.

The accrual basis of accounting is superior and presents better picture of overall financial perfornance when compared to cash basis. The above statement can be appreciated by looking at the following example:

Let us assume a company which sells the goods only for cash and also have the feasibility to buy a portion of its stock on credit basis. Now the entire sale income is recognised during the year in case of cash based accounting as the entire amount is received in cash However the purchases on credit basis are not recognised as expense since they were not actually paid in cash and hence results in inflation of profit. Now conversely let us assume a company which sells goods both on cash and credit basis but does not have the benefit of purchasing goods on credit. In this situation, if cash basis of accounting is adopted, even though the entire amount paid towards purchases are recognized as expenses, the amount attributable to credit sale durin the year are not recorded in the books since cash was not actually received.

Depreciation is charge of portion of cost of asset to the statement of income. The concept of depreciation is derived from the matching concept which emphasises that the firm should recognize all the income along with all the corresponding expenses which resulted the said incomes. In case of long-term assets, even though the entire cash outlay would have occured at the time of acquiring suce asset, the benefits that can be availed from such assets are distributed over the economic useful life of the asset and hence depreciation is an attempt of expecting the portion of cost of asset which has caused the income / benefits during the year and charging the same to income statement to decide surplus / deficit generated

Adjustment entries for recording depreciation:

If depreciation is directly charged to carrying cost of asset:

For charging depreciation:
Dr>> Depreciation Expense A/c
Cr>> Corresponding Asset A/c

For transferring depreciation expense to P&L A/c:
Dr>> Profit and Loss A/c
Cr>> Depreciation Expense A/c

If depreciation expense is accumulated in accumulated depreciation a/c

For charging depreciation:
Dr>> Depreciation Expense A/c
Cr>> Accumulated Depreciation A/c

For transferring depreciation expense to P&L A/c:
Dr>> Profit and Loss A/c
Cr>> Depreciation Expense A/c