Cash accounting refers to a process of accounting for transactions where ledger and journal entries are made when cash is received or spent (Palepu, 2007). This method is most commonly used in small business. Under this method, there is no need for income until they receive cash, and expenses are not supposed to be in the record until paid. Transactions carried out are supposed to reflect into records when money actually changes hands. For example, customers in a small business store pay for goods and services with cash. Therefore, the store accountant records cash sales as revenues. The relationship between accrual accounting and cash flows is illustrated in the following chart:
Flowchart 1: The linkage between accrual accounting and cash flows
In accrual accounting, they record revenue in the book as soon as the cash is realized and not when the cash is actually received. This means that the business records the income as soon as a business deal or contract is sealed. Financial statement reflects expenses as soon as they take obligation to pay for goods and services, regardless of the time they actually receive it (Epstein, 2008). It helps financial institution to record economic activities in the period which they occur, whether cash is part of it or not. For example, a business records October the total sales which has accumulated as revenues despite payment been done next year on February.
Accrual accounting provides a better sense of the rate at which the business is expanding. It can hide cash flow problems, only because the financial statement will show revenue that is not there. Cash accounting reflects the amount of money they have at any given time (Palepu, 2007). Additionally, cash accounting can mask all the unpaid debts. This method is not efficient since it may not provide a company true economic standing because it entails liquidity transactions. The accrual and the cash methods are the two principal methods of keeping track of a business’ expenses and revenue. Both methods are reliable, but the only difference occurs in the time of making entries, including purchases and sales, are credited or debited to business accounts (Palepu, 2007).
Epstein, B. J., & Jermakowicz, E. K. (2008). Wiley IFRS 2008: Interpretation and application of international accounting and financial reporting standards 2008. Hoboken, N.J: Wiley.
Palepu, K. G. (2007). Business analysis and valuation: IFRS edition, text only. London: Thomson Learning.