Most companies have at their core transactions of the company with its customers, regarding money going in and out of the company. Companies have to track these transaction, and use the transactions for future referencing and measure current performance. Financial accounting deals with the recording of these transactions and summarizing them and presenting the information in financial statements, showing the firm's financial situation. Financial statements are only as good as the recording of the transactions themselves. There are two preliminary methods to record transactions in a business. The cash basis which simply records transactions when the company receives or pays out money. If a transaction occurs but no money is received or paid, the transaction is not recorded. Accrual basis accounts records when the transaction actually happens and not when money or goods are exchanged, this takes into account for example credit sales. Financial statements are very important, they can be used by company owner and directors to monitor progress of company, or by a capitalist to know whether or not to invest in a certain firm.
Cash basis statements simply show revenue and expenses in a simple cash flow statement, and only show revenue when actual money is received, and expense when actual money is paid out. But now a day's most transaction don't involve the exchange of money immediately, firms can buy products on credit, which is a major drawback of cash based statements. Someone may look at a cash based statement and see that the company has made large revenue, when in fact, the company has bought new stock on credit and will have to pay a large amount out of its revenue to its creditors. Not noticing and not keeping track of creditors in the statements is dangerous for any business which buys in credit, because if not paid the company could go into liquidation. This is a major drawback of cash based statements one which is not existent in accrual based statements, because accrual based accounting takes into account credit sales, and records them in the financial statements.
Income statements and trial balances are major financial statements to a business, and extracting the required data for the statements from a cash basis system is hard and will lack important information, such as creditors, making hard to draw up these statements. Therefore it will be hard to follow the firms progress. Without an adequate trial balance and income statement derived from the cash basis system, it would also be hard to make adjustment entries, which most companies have. With the accrual cased system, it is easier to make adjustment entries to the statements, both deferrals and accrual adjustments.
Another disadvantage with cash based statements, is that it doesn't show the companies debtors, so a company may have made a large sale on credit, but this won't show on the financial statements. Anyone looking at the statements would think that the firm is not making revenue, when in fact it is making revenue, but it yet to receive the money for it. This disadvantage is not apparent in accrual based statements which show takes into account debtors, and counts it as the firms short term assets. Cash based statements would fail to serve large companies who sell and buy on credit, as these sales won't be recorded.
Accrual accounting records transaction when the transaction occurred and not when money is received therefore, statements based on accrual accounting illustrate how the company is actually doing. Credit sales and purchases would be shown in the statements, therefore, the company knows who and how much it owns and how much is owned to the company, which is a very important matter for business. This is a very important advantage accrual based accounting has over cash based