Differences between accrual-basis financial statements and cash-basis financial statements
Discuss the differences between accrual-basis financial statements and cash-basis financial statements. Determine which provides more useful information and the reasons it is more useful.
In accounting, there are two methods of recording the revenue and expenses of a business entity. The "cash basis method" is a method that records revenue when cash is received and records expenses when cash is spent. The "accrual basis method" is a method that records revenue when it's earned (whether or not it's been received) and expenses when they are incurred (whether or not they've been paid).
For accounting and tax purposes, the accrual basis method is generally considered to be the most accurate and give the most useful information. Therefore, accrual basis financial statements give a better overall picture of the financial health of an organization and are used by almost all larger companies. I will explain why in the following paragraph.
Most large companies have customers that buy on a continual basis, generating an endless supply of revenue. Their transactions are recorded in a ledger entitled Accounts Receivable. Any purchase made increases their balance, and any payment made decreases it. At the same time, a company has to buy supplies and services on account on a continual basis to keep their business running. An Accounts Payable ledger is used to record these transactions in which additional purchases from the supplier increase the balance owed and payments to him decrease the balance owed. Many financial lending institutions will use this income:debt ratio (accounts receivable vs. accounts payable) as a basis of determining a company's financial stability in order to grant loans or revolving lines of credit.
The Internal Revenue Service and the accounting industry have recognized the accrual basis method as one of its most generally accepted accounting principles, given its more accurate view of a company's financial status.