Cash basis accounting vs accrual basis accounting
There are two methods of accounting a business may use to record their transactions; cash basis accounting and accrual basis accounting. While both are effective, most businesses choose accrual basis accounting because cash basis accounting is not an acceptable form of accounting under Generally Accepted Accounting Principles (GAAP). However a small business may still elect to use this method. (Nobles, Mattison, Matsumura. 134)
Cash basis accounting only records cash transactions, which gives little insight to the true financial position of a business. Where as, accrual basis accounting reports events as they occur. Income is only reported when earned and expenses are only reported when incurred. Since cash is always recorded when it is received an accountant will have to make adjustments to the financial statements to account for its prepaid and accrued expenses. (Nobels, et al. 134)
A prepaid adjustment is where expenses are paid in advance for future expenses. Now, the business must record the transaction when the cash is paid, but it must record accurately the expense as it is incurred. For example, a business may choose to prepay its rent for three months. Suppose they pay $3000 in January for the next three months rent. The cash payment is recorded in January, but the accountant must make an adjustment each month for the rent expense as it is incurred. Therefore, each month the accountant must make an adjustment for $1000 to account for that months rent expense. Originally the accountant would record a debit to the prepaid cash account and a credit to cash in the amount of $3000. When making the adjustment the accountant would then record a debit to the rent expense account and a credit to the prepaid rent account in the amount of $1000, each month for the next three months. (Nobels, et al. 139)
Another example of a prepaid transaction is recording the depreciation of plant assets. A plant asset is any asset the business has that may depreciate in value
Cash basis accounting only records cash transactions, which gives little insight to the true financial position of a business. Where as, accrual basis accounting reports events as they occur. Income is only reported when earned and expenses are only reported when incurred. Since cash is always recorded when it is received an accountant will have to make adjustments to the financial statements to account for its prepaid and accrued expenses. (Nobels, et al. 134)
A prepaid adjustment is where expenses are paid in advance for future expenses. Now, the business must record the transaction when the cash is paid, but it must record accurately the expense as it is incurred. For example, a business may choose to prepay its rent for three months. Suppose they pay $3000 in January for the next three months rent. The cash payment is recorded in January, but the accountant must make an adjustment each month for the rent expense as it is incurred. Therefore, each month the accountant must make an adjustment for $1000 to account for that months rent expense. Originally the accountant would record a debit to the prepaid cash account and a credit to cash in the amount of $3000. When making the adjustment the accountant would then record a debit to the rent expense account and a credit to the prepaid rent account in the amount of $1000, each month for the next three months. (Nobels, et al. 139)
Another example of a prepaid transaction is recording the depreciation of plant assets. A plant asset is any asset the business has that may depreciate in value
Cited: Sources Nobles, Tracie, Mattison, Brenda and Matsumura, Ella Mae. Horngren’s Accounting. Upper Saddle River: Pearson, 2014. Print.