Question

You have formed a new sole proprietorship and your primary business is buying and selling fine art. Your business is not publicly traded so you can choose to use the cash basis method or the accrual method for your business. Which would you use and why?

Answer 1

I would have chosen the accrual method of accounting considering the nature of the business we work in. Purchase and sale of fine art involve dealing in huge amount as such goods of high value. Also, wherever, the high quantum of the transaction is there, therefore, payments are generally after a delay or in installments.

Giving credit to customers is also a normal thing in the business we are involved in. In accrual accounting, we are required to record the transactions on an accrual basis i.e. as and when they occur, unlike cash basis where transactions are recorded only when cash transactions are made.

It is believed that Cash basis will not be able to give a clear image of the profitability of the business, this can be further explained with below example:

Example:

We sold an art for $5,000 to a customer on credit and purchased another one from our supplier for $3,500 in cash. We also received a cash of $3,000 from a customer for invoices raised in last month.

Solution: As per cash basis we will have a loss of $500 ($3000-$3,500).

However, as per accrual basis, we will have a profit of $1500 ($5000 - $3500).