Cash Basis Vs Accrual Basis of Accounting

Many small businesses use cash basis of accounting to record transactions, especially those who prepare the accounts once a year. Please refer to my post: Preparing Accounts of Small Businesses Once A Year – Tips and Pitfalls To Avoid for further illustrations.

Indications that cash basis of accounting is used includes the following:-

  • No books of original entry such as sales day book and purchases day book used to record sales and purchases.
  • No debtors ledger or creditors ledger maintained.
  • All receipts and payments are recorded directly in cash book.

Cash basis of recording transactions and presenting the financial statements produced has long been deemed an inappropriate basis to use. Accrual basis of accounting is the accepted basis and this is stated in International Accounting Standard (IAS) 1: Presentation of Financial Statements.

It is good if a business entity is aware of the difference between cash basis and accrual basis of accounting and records its transactions using accrual basis. However, for those businesses who have recorded the transactions using cash basis do not need to discard those set of accounts produced and record all past transactions using accrual basis of accounting all over again. What need to be done is re-examine all the account items that have been produced using cash basis of accounting to determine as to whether any adjustment is required to adjust those items should accrual basis of accounting is used. Some examples: –

  1. Sale of goods

    Under cash basis of accounting, all proceeds collected from sales are recorded in the accounting records upon receiving payments from customers. The balance sheets produced using cash basis of accounting do not show any trade debtor balances! Those sales figures shown in the income statements represent only cash sales. No credit sales are recorded.

    The solution is to identify all bills and invoices of those sales in which the transactions have occurred as at the end of the financial year, but still unpaid, i.e. those unpaid sales invoices or bills and put through a journal adjustment to recognise the credit sales and trade debtors as follows: –

    Balance Sheet

    Income Statement

    DR

    CR

    DR

    CR

    Trade debtors

    XXXX

    Sales

    XXXX

    A point to note on the criteria used to determine the occurrence of transactions (sales recognition in this case) is usually based on delivery and acceptance of goods by customers. You may have come across the solution because I have discussed this in Step 4a, The Worst Case Scenario of my post: Preparing Accounts of Small Businesses Once A Year – Tips and Pitfalls To Avoid.

  2. Purchase of goods

    This is the opposite of sales of goods discussed above. Similarly, the balance sheets produced under cash basis of accounting will not show any trade creditor balances. The purchases figures shown in the income statements represent only cash purchases. No credit purchases are recorded.

    The solution is the same as discussed in sale of goods above. You need to identify all unpaid bills and invoices in which the transactions have occurred as at the end of the financial year, but still unpaid, i.e. those unpaid purchase invoices or bills and put through a journal adjustment to recognise the credit purchases and trade creditors as follows: –

    Balance Sheet

    Income Statement

    DR

    CR

    DR

    CR

    Purchases

    XXXX

    Trade Creditors

    XXXX

  3. Prepayments
  4. Some expenses are paid now but part of them or the entire sums are meant for future period. This is the reason that they are called “Prepayments”. Under cash basis of accounting, prepayments are usually recorded as the respective expense accounts. What is required here is an adjustment to recognise the prepayments as current assets i.e. those portion of the payments that are meant for the next financial year.

    The original double entry recording the transactions when payments are made: –

    Balance Sheet

    Income Statement

    DR

    CR

    DR

    CR

    Expenses

    XXXX

    Cash at bank

    XXXX

    Adjustment for prepayments recognition:-

    Balance Sheet

    Income Statement

    DR

    CR

    DR

    CR

    Prepayments

    XXXX

    Expenses

    XXXX

    Example

    The financial period of ABC Co. Ltd. is from 1 January 2007 to 31 December 2007. On 1 November 2007, ABC Co. Ltd. paid the insurance premium for its fire policy covering the period from 1 December 2007 to 30 November 2008. The amount paid was $2,400. The prepayment for insurance is therefore $2,200 ($2,400/12 months x 11 months for the period from 1 January 2008 to 30 November 2008).

    The original double entry recording the transactions when payments are made: –

    Balance Sheet

    Income Statement

    DR

    CR

    DR

    CR

    Insurance premium

    2,400

    Cash at bank

    2,400

    Adjustment for prepayment recognition:-

    Balance Sheet

    Income Statement

    DR

    CR

    DR

    CR

    Prepayments

    2,200

    Insurance premium

    2,200

    The balance sheet and income statement of ABC Co. Ltd. before and after this adjustment for prepayment recognition are shown below to illustrate the impact of this adjustment: –

Example of Income Statement and Balance Sheet of ABC Co. Ltd.
Income Statement for the year ended 31 December 2007

BEFORE

Adjustment

AFTER

DR

CR

$

$

Sales

159,270

159,270
Cost of Sales

– 90,875

– 90,875
Gross profit

68,395

68,395
Other income: –
Interest income

2,356

2,356
Operating expenses: –
Accountancy fee

-800

– 800
Depreciation of property, plant and equipment

-2,500

– 2,500
Donation

-500

– 500
Electricity & water

-3,340

– 3,340
Insurance premium

-2,400

2,200 – 200
Printing & stationery

– 1,697

– 1,697
Rental of premises

-12,000

– 12,000
Salaries

-35,579

– 35,579
Upkeep of office

-3,547

– 3,547
Telephone charges

-1,285

– 1,285
Travelling, petrol & toll charges

-2,648

– 2,648

-66,296

– 64,096
Net profit for the year

4,455

6,655
Retained profits B/F

27,654

27,654
Retained profits C/F

32,109

34,309
Balance Sheet as at 31 December 2007

$

$

Non-current assets
Property, plant and equipment

15,000

15,000
Current assets
Inventories

5,200

5,200
Trade receivables

6,000

6,000
Other receivables, deposits & prepayments:
Sundry receivables

1,058

1,058
Deposits

2,000

2,000
Prepayments

2,200 2,200
Amount due by shareholders

13,375

13,375
Cash and bank balances

10,639

10,639

38,272

40,472
Current liabilities
Trade payables

-3,588

– 3,588
Other payables and accruals

-2,575

– 2,575

-6,163

– 6,163
Net current assets

32,109

34,309

47,109

49,309
Financed by: –
Share capital

15,000

15,000
Retained profits

32,109

34,309

47,109

49,309
  1. Interest income

    Business entities may place excess cash as term deposits with financial institutions to earn interest income. Under cash basis of accounting, there was no interest income recognised and recorded in the accounts until the business entities receive the interest upon maturity of the term deposits.

    However, under accrual basis of accounting, the amount of interest attributable to the relevant period of the deposits placement must be calculated and recognised accordingly. For examples, the financial period of ABC Co. Ltd. is from 1 January 2007 to 31 December 2007. On 1 July 2007, ABC Co. Ltd. placed $100,000 with its bank as term deposit for 1 year. The interest rate is 3.5% per annum. The interest earned from 1 July 2007 to 30 June 2008 is $350 ($100,000 x 3.5%). In respect for the accounts of ABC Co. Ltd. for the year ended 31 December 2007, the portion of the interest income to be recognised is $175 ($350 x 6months/12months for the period from 1 January 2007 to 31 December 2007).

    The journal adjustment to recognise this interest income is as follows: –

    Balance Sheet

    Income Statement

    DR

    CR

    DR

    CR

    Interest receivable

    175

    Interest income

    175

    The balance sheet and income statement of ABC Co. Ltd. before and after this adjustment for interest income recognition are shown below to illustrate the impact of this adjustment: –

Example of Income Statement and Balance Sheet of ABC Co. Ltd.
Income Statement for the year ended 31 December 2007

BEFORE

Adjustment

AFTER

DR

CR

$

$

Sales

159,270

159,270
Cost of Sales

-90,875

– 90,875
Gross profit

68,395

68,395
Other income: –
Interest income

175 175
Operating expenses: –
Accountancy fee

-800

– 800
Depreciation of property, plant and equipment

-2,500

– 2,500
Donation

-500

– 500
Electricity & water

-3,340

– 3,340
Insurance premium

-200

– 200
Printing & stationery

– 1,697

– 1,697
Rental of premises

-12,000

– 12,000
Salaries

-35,579

– 35,579
Upkeep of office

-3,547

– 3,547
Telephone charges

-1,285

– 1,285
Travelling, petrol & toll charges

-2,648

– 2,648

-64,096

– 64,096
Net profit for the year

4,299

4,474

Retained profits B/F

27,654

27,654
Retained profits C/F

31,953

32,128
Balance Sheet as at 31 December 2007

$

$

Non-current assets
Property, plant and equipment

15,000

15,000
Current assets
Inventories

5,200

5,200
Trade receivables

6,000

6,000
Other receivables, deposits & prepayments:
Interest receivable

175 175
Deposits

14,077

14,077
Prepayments

2,200

2,200
Fixed deposit with licensed bank

100,000

100,000
Cash and bank balances

10,639

10,639

138,116

138,291
Current liabilities
Trade payables

-3,588

– 3,588
Other payables and accruals

-102,575

– 102,575

– 106,163

– 106,163
Net current assets

31,953

32,128

46,953

47,128
Financed by: –
Share capital

15,000

15,000
Retained profits

31,953

32,128

46,953

47,128

On 30 June 2008, when the deposit matures and interest of $350 is received by ABC Co. Ltd., the double entry to record these transactions is as follows:-

Balance Sheet

Income Statement

DR

CR

DR

CR

Cash at bank

100,350

Fixed deposit with licensed bank

100,000

Interest receivable

175

Interest income

175

The balance sheet and income statement of ABC Co. Ltd. for the year ended 31 December 2008 before and after this adjustment are shown below to illustrate the impact of this adjustment: –

Example of Income Statement and Balance Sheet of ABC Co. Ltd.
Income Statement for the year ended 31 December 2008

BEFORE

Adjustment

AFTER

DR

CR

$

$

Sales

109,270

109,270
Cost of Sales

– 40,875

– 40,875
Gross profit

68,395

68,395
Other income: –
Interest income

175 175
Operating expenses: –
Accountancy fee

– 800

– 800
Depreciation of property, plant and equipment

– 2,500

– 2,500
Donation

– 500

– 500
Electricity & water

– 3,340

– 3,340
Insurance premium

– 200

– 200
Printing & stationery

– 1,697

– 1,697
Rental of premises

– 12,000

– 12,000
Salaries

– 27,865

– 27,865
Upkeep of office

– 3,547

– 3,547
Telephone charges

– 1,285

– 1,285
Travelling, petrol & toll charges

– 2,648

– 2,648

– 56,382

– 56,382
Net profit for the year

12,013

12,188
Retained profits B/F

27,654

27,654
Retained profits C/F

39,667

39,842
Balance Sheet as at 31 December 2007

$

$

Non-current assets
Property, plant and equipment

10,000

10,000
Current assets
Inventories

5,000

5,000
Trade receivables

17,030

17,030
Other receivables, deposits & prepayments:
Interest receivable

175

175

Deposits

14,077

14,077
Prepayments

2,200

2,200
Fixed deposit with licensed bank

100,000

100,000

Cash and bank balances

12,348

100,350 112,698

150,830

151,005
Current liabilities
Trade payables

-3,588

– 3,588
Other payables and accruals

-102,575

– 102,575

-106,163

– 106,163
Net current assets

44,667

44,842

54,667

54,842

Financed by: –
Share capital

15,000

15,000

Retained profits

39,667

39,842

54,667

54,842

Out of the $350 interest received, $175 was credited to the interest receivable account and $175 is credited to the interest income account for the year ended 31 December 2008 (for the interest earned for the period from 1 January 2008 to 31 December 2008.

The interest was calculated based on simple interest method. For illustrations on the difference between simple interest and compound interest, please refer to my post: Effective Interest? Simple Interest? Compound Interest? Nominal Interest?

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