The cash basis of accounting recognizes revenue and expenses at the time of actual receipt or payment of cash. The cash basis of accounting is less accurate than the accrual basis of accounting as they affect the company’s books only when a complete exchange of value has occurred. Cash basis of accounting might be easier and cheaper to maintain but the needs of users of financial statements are not satisfied due to the inaccurate nature of this method.
Example
A construction company secures a contract for the construction of a stretch of Delhi Metro and will receive the payment for the same from DMRC at the completion of construction. Using cash basis of accounting, revenue would be recognized only on the completion of the project, while the expenses will be recorded as and when they have been paid out. Generally, projects take more than a year to complete; in such scenarios, the income statement of the company would be misleading as the company will incur large losses in one year and abnormally high profits in the next year.
Advantages
- Maintaining books on a cash basis is comparatively easier and cheaper.
- More rational approach as it is based on actual cash inflows and outflows.
- A more suitable approach for entities with most of the transactions taking place in cash.
Disadvantages
- Fails to exhibit the true and fair view of the financial performance and financial position as it ignores outstanding and prepaid expenses and unearned and accrued incomes.
- This method is inconsistent with the matching principle of accounting.
- Cash basis of accounting allows easy manipulations of profits. To reflect a better financial position, payments may be delayed and amounts due may be collected before due dates and vice-versa.
Also, Read
International Financial Reporting Standards (IFRS)
International Financial Reporting Standards are designed to serve as a common global language of business affairs so that accounts of various companies are understandable and comparable across international boundaries.