Accrual basis of accounting is one of the underlying assumption for preparing financial statements under International Accounting Standards. IASB Framework clearly demanded the financial statements to be prepared on accrual basis instead of cash basis of accounting.
Among other notable benefits of usig accrual basis of accounting over cash basis is that it helps record the event more accurately as they record the event as and when it is happening and a resultant asset or obligation arising out of transactions. This way user of financial statement will have better understanding of the business’s financial position and performance in past and future times.
Cash basis delays reporting until the cash flows in or out and due to this fact information is either incomplete or not reported in the period to which it relates and also by that time the information would have become too stale to be used for decision making purposes or relevant for other information needs of the user.
Give an example comparing cash and accrual basis of accounting and its effect on recording and reporting.
For example sales were made in the month of July on credit basis worth 2,000 and half of the price is paid upfront and rest is promised to be paid in next three months. Then reporting of this transaction under accrual basis and cash basis will be as mentioned below:
Accrual basis: Sales of 2,000 will be recorded i.e. business will record income of 2,000 and a receipt of 1,000 whereas another 1,000 will be reported as receivable from customer i.e. amount to be received within immediately following year.
Cash basis: Sale of 1,000 will be recorded as only 1,000 has been received and the same will be recorded as receipt as well. No receivables will arise as under cash basis accounting entry is made only when cash flow occurs. Rest of the sales will be recorded in the month of October when cash will actually flow in.
In above example it is evident that accrual basis of accounting not only helps reflecting past events, entities current financial standing and also the expected future events. Whereas in cash basis information was incomplete in the month of July and user will have no idea of actual amount of sales and the possible inflow of cash in future. And by the time receipt of other half will be recorded i.e. month of October until not only this information is irrelevant as it relates to the month of July but also cause distortion in the results pertaining to the month of October i.e. inflating the revenue of October by 1,000 wrongly as this amount relates to month of July’s sales.