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. Please refer to: Various Types of Transactions – Part 3, Collection from Sales or Services Rendered for further illustrations. 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
   

   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




4. 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?