The conventions and standards applied in U.S for purposes of offering uniformity in the financial statements and also in accounting are known as the Generally Accepted Accounting Principles (GAAP). The recommended accounting method by GAAP is not the cash basis but the accrual based system.
There are other reasons for presenting accounts in a different basis. Among them is the fact that it could be more in line with how the financial statements of an organization are reviewed for purposes of budgeting. However various funding institutions such as bankers typically understand the GAAP system.
On the other hand, most small businesses that are non-incorporated apply cash basis method without experiencing any problem. The moment small business begin to grow, obtain loans and attract investors, they may consider using the mandatory accrual method which is a must for businesses whose sales exceed $ 5 million or incase sales and inventory sums up to $ 1 million annually.
The main difference between the accrual and cash basis of accounting relates to the timing of expenses and revenue. In the cash basis of accounting, revenue is recognized when money is received while expenses are recognized when money has been paid out. Accounts receivables and accounts payables are not recognized by the cash basis. For instance, it is only when a bill is paid is an expense recognized.
On the other hand, revenues are usually recognized when earned in the accrual basis of accounting. This means that revenue is recorded by the company when earned even though the customer has not yet made the payment. For instance, in the case of a contractor who uses the accrual system of accounting, he will record the total earned revenue when the job is completed and even though the final bill has not yet been paid by the customer. Expenses are also similarly treated; upon their occurrence as opposed to when payment is made.
Benefits and Disadvantages
The main advantage of the cash basis is that it is not only simple but also flexible and cash flows are also taken into consideration. Unless received, income is never taxed. Lack of control of accounts payables and receivables is the main disadvantage of this method and particularly the long term ones. The cash basis gives a narrow view of managing finances in a business. Running a business takes more than just seeing money coming in and out.
The main advantage of the system of accrual is that it gives an ideal picture of real expenses and income within a certain time period. Unlike the cash basis of accounting, the accrual method offers a long term business picture. The main disadvantage with this method is that the cash flow as well as its analysis may take the back seat. Additionally, the accrual accounting basis is more complex compared to cash method.
Areas of Consideration
Financial statements and other reports can be prepared using the cash basis or accrual basis. A Balance sheet made on accrual basis will for example show the accounts payables and accounts receivables and may also present the prepaid expenses and deferred revenue. None of these accounts will be shown in a report of cash basis; rather, it will only show the equity and cash.
For the case of an income statement, one requires considering if the reported revenue consists of only money received, an indication of a statement based on cash or incase the revenue comprises of invoices sent; an indication of a report based on accruals.