Question

Distinguish between cash-basis accounting and accrual-basis accounting. Why is accrual-basis accounting acceptable for most businesses and the cash-basis unacceptable in the preparation of an income statement and a balance sheet?

Short answer

The primary difference between cash-basis and accrual basis accounting is that in cash-basis accounting, the listing is done when the money comes in and goes out of the business. While in the accrual-basis accounting, the income and the expenses are recorded as soon as they occur.

Accrual-basis accounting is acceptable for businesses because it provides a fair view of a firm’s finances. However, cash-basis accounting is unacceptable as the timing of cash flows does not indicate the suitable timing of changes in the economic condition of the business.

Step-by-step solution

Step-by-Step SolutionStep 1: Meaning of Accounting

Accounting is defined as the process of determining a company's transactions and supplying information about its financial position to its potential users. This is particularly useful for identifying information for each transaction.

Difference between cash-basis and accrual-basis accounting

In the cash basis of accounting, revenue is recognized only when there is a cash receipt, and expenses are listed only when disbursed. On the other hand, in the accrual basis of accounting, revenue is realized when a performance liability is fulfilled, and expenses are listed when incurred without considering the time of receipt or cash disbursement.

Acceptance of accrual-basis of accounting in the preparation of income statement and balance sheet

A cash-basis balance sheet and income statement are insufficient and incorrect relative to accrual-basis accounting statements. The accrual-basis equalizes the expenses and revenues in the income statement, while the cash-basis only indicates the cash receipts and payments. The accrual-basis balance sheet comprises accruals, deferrals, receivables, payables, and prepayments; on the other hand, a cash-basis balance sheet does not reflect any of these. Therefore, the accrual basis of accounting is usually preferred by businesses over the cash-basis.