Basis of Accounting

  • Cash Basis of Accounting is a system of accounting in which entries in the book of accounts are recorded only when cash is received or paid. Credit transactions are not recorded till cash is actually received or paid for them. Income or profit is calculated with the help of a Receipts and Payments Account.
  • Advantages of cash basis of accounting are that it is simple to use and does not require technical knowledge of accountancy, it does not require the use of estimates and personal judgments, suitable for firms having most of the transactions in cash, etc.
  • Disadvantages of cash basis of accounting are that it does not give a true and fair view of profit and loss and the financial position of the business enterprise; it does not follow the matching principle of accounting and is not recognised by the Companies Act, 2013.
  • Inaccrual basis of accounting, income if earned or accrued during the period whether received or not is included in the income of that period. Expenses are recorded when they are incurred or become due and not when the cash is paid for them.
  • Accrual basis of accounting is based on the two basic accounting principles, viz., revenue recognition and matching principle. Accrual basis of accounting is scientific and rational basis of accounting, hence discloses correct profit or loss.
  • It follows the matching principle of Accounting. Accrual basis of accounting can be (or in fact is) used in all type of business enterprises.
  • Disadvantages of Accrual Basis of Accounting are that this method is not as simple as Cash basis of accounting and the accounting process is too elaborate etc. Cash basis of accounting can be differentiated from accrual basis of accounting on the basis of several points like recording of cash and credit transactions, recognised by law or not, requirement of adjustment for certain items, suitability etc.
  • Hybrid Basis of Accounting is a mixed basis of accounting. It is a mixture of cash and accrual basis of accounting.

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  • Q1

    What do you mean by Accrual Basis of Accounting? List its advantages and disadvantages.

    Marks:6
    Answer:

    Under the Accrual Basis of Accounting, incomes are recorded when they are earned or accrued, irrespective of the fact whether cash is received or not, e.g., sales made on credit will be included in the total sales of the period. In the same way, expenses are recorded when they are incurred or become due and not when the cash is paid for them. For example, the rent due to the landlord but not paid will be treated as expense for the period when it is due and not in the period, it is paid. The Profit or Loss of a particular period is the result of matching of the revenues earned and expenses incurred during the period. So, it is necessary to consider outstanding expenses, prepaid expenses, accrued income, income received in advance etc. for the preparation of the financial statements. According to the Companies Act, 2013, all companies are required to maintain their accounts as per accrual basis of accounting.

    Advantages:
    (i) It is more scientific as compared to Cash Basis of Accounting and therefore, it is preferred by accountants.

    (ii) It shows a complete picture of financial transactions of the business as it takes into account the effect of all the transactions relating to a period as well as adjustments such as outstanding expenses, prepaid expenses, accrued income and income received in advance.

    (iii) It discloses true profit or loss for a particular period and also depicts the financial position of the business at the end of a particular period. This system is followed by most of the industrial and commercial firms.

    (iv) It follows the matching principle of accounting.

    (v) It is recognised by Companies Act, 2013.



    Disadvantages:
    (i) It is not as simple as Cash Basis of Accounting.
    (ii) The process of accounting is too elaborate.
    (iii) It requires the use of estimates and personal judgments.

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  • Q2

    What do you mean by Cash Basis of Accounting? List its advantages and disadvantages.

    Marks:4
    Answer:

    Under the Cash Basis of Accounting, incomes are not recorded unless they are received in cash. In the same way, expenses are recorded as incurred only when they are paid in cash. In other words, entry is not recorded when a payment or receipt is merely due. The difference between the total incomes and total expenses represents Profit or Loss. Income or Profit is calculated with the help of Receipts and Payments Account. This basis is found useful for professional people like lawyers, doctors, chartered accountants etc.

    Advantages:
    (i) It is very simple as adjustment entries are not needed.
    (ii) It does not need the use of estimates and personal judgments.
    (iii) It is suitable for those enterprises where most of the transactions are made on the cash basis.

    Disadvantages:
    (i) It does not give a true and fair idea of profit or loss and financial position of an enterprise because it ignores outstanding expenses, prepaid expenses, accrued income and income received in advance.
    (ii) It does not comply with the matching principle of accounting.
    (iii) As capital and revenue items are not distinguished in cash basis, no consistency is found in the profits of different years.

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  • Q3

    Suggest the basis of accounting to be adopted by a doctor for his own clinic.

    Marks:1
    Answer:

    Cash Basis of accounting is more appropriate for a doctor because a medical practitioner receives his fee immediately after giving consultancy.

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  • Q4

    What do you mean by accrual basis of accounting?

    Marks:1
    Answer:

    Accrual basis of accounting means that a transaction is recorded in the books of accounts at the time of earning an income or incurrence of expense irrespective of actual receipt or payment.

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  • Q5

    What do you mean by cash basis of accounting?

    Marks:1
    Answer:

    Cash basis of accounting means that a transaction is recorded in the books of accounts at the time of receipt or payment actually made in cash.

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