Why is the cash basis of accounting not used when preparing financial statements?
The cash basis of accounting is a method that recognizes revenue and expenses only when cash is received or paid out, respectively. While it may be simpler for small businesses to use the cash basis for record-keeping, it is generally not suitable for preparing financial statements for several reasons:
1. Accrual-based accounting: Financial statements are typically prepared using accrual-based accounting, which recognizes revenue when it is earned and expenses when they are incurred. This provides a more accurate picture of a company's financial performance and position, as it matches revenues and expenses to the period to which they relate, rather than when cash is exchanged.
2. Matching principle: The accrual basis of accounting adheres to the matching principle, which requires recognizing expenses in the same period as the revenues they help generate. This principle ensures that the financial statements accurately reflect the cause-and-effect relationship between revenues and expenses, facilitating more meaningful analysis and decision-making.
3. Long-term obligations: The cash basis ignores long-term liabilities and assets, such as loans payable, accounts receivable, and depreciation. Financial statements prepared under the cash basis would not include these important elements, leading to an incomplete and inaccurate representation of a company's financial position.
4. Comparability: The accrual basis of accounting allows for better comparability over time and between different organizations. Financial statements prepared using the same accounting basis enable stakeholders to make more informed comparisons and evaluations of performance, profitability, and financial health.
In summary, the cash basis of accounting may be useful for day-to-day record-keeping but is not suitable for preparing financial statements. Accrual accounting provides a more accurate and comprehensive representation of a company's financial performance, position, and long-term obligations.