Q. Explain cash basis of accounting?

Professionals such as lawyers and physicians and some relatively small businesses may account for their revenues and expenses on a cash basis. The cash basis of accounting knows revenues when cash is received and recognizes expenses when cash is paid out. For instance under the cash basis a company would treat services rendered to clients in 2010 for which the company collected cash in 2011 as 2011 revenues. Likewise under the cash basis a company would treat expenses incurred in 2010 for which the company disbursed cash in 2011 as 2011 expenses. In the "pure" cash basis even the purchase of a building would be debited to an expense. But under the "modified" cash basis the purchase of long-lived assets such as a building would be debited to an asset and depreciated gradually charged to expense over its useful life. Usually the "modified" cash basis is used by those few individuals and small businesses that use the cash basis.

For the reason that the cash basis of accounting does not match expenses incurred and revenues earned, it is in general considered theoretically unacceptable. The cash basis is adequate in practice only under those circumstances when it approximates the results that a company could obtain under the accrual basis of accounting. Companies using the cash basis don't have to prepare any adjusting entries unless they discover they have made a mistake in preparing an entry during the accounting period.