SingaporeAccountingSyllabus dot point

Why do financial statements use the accrual basis rather than simply recording cash in and out?

Distinguish the accrual basis from the cash basis and explain why accrual accounting gives a more useful measure of performance

A focused answer to the H2 Principles of Accounting outcome on the accrual and cash bases. How each recognises income and expenses, the role of accruals and prepayments, and why accrual profit differs from cash flow.

Generated by Claude Opus 4.89 min answerUpdated 2026-06-06

Reviewed by: AI editorial process; not yet individually human-reviewed

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What this dot point is asking
The answer
Examples in context
Try this

What this dot point is asking

SEAB wants you to distinguish the accrual basis from the cash basis and to explain why accrual accounting gives a more useful measure of a period's performance. This dot point underpins every adjustment in the syllabus: accruals, prepayments, depreciation and impairment all exist because we report on the accrual basis. The central insight is that profit and cash flow are different things, and that the accrual basis deliberately separates the timing of recognition from the timing of cash.

The answer

The two bases compared

Feature	Cash basis	Accrual basis
Income recognised	When cash is received	When earned (goods or services delivered)
Expense recognised	When cash is paid	When incurred (benefit consumed)
Receivables and payables	Ignored	Recognised as assets and liabilities
Matching	No	Yes - costs matched to the revenue they earn
Used for	Very small or simple records	All published financial statements

Under the cash basis, profit is simply cash in minus cash out. Under the accrual basis, profit is income earned minus expenses incurred, which requires year-end adjustments to move items into the correct period.

Accruals and prepayments

The accrual basis works through four adjustment types:

Accrued expense: incurred but not yet paid (for example wages owed). Add to expenses; record a liability.
Prepaid expense: paid but relating to a future period (for example rent in advance). Remove from expenses; record an asset.
Accrued income: earned but not yet received (for example interest due). Add to income; record a receivable.
Deferred income: received but not yet earned (for example a subscription paid in advance). Remove from income; record a liability.

These adjustments convert cash figures into accrual figures, which is the routine task that turns a trial balance into proper financial statements.

Why accrual is more useful

The accrual basis gives a better measure of performance because it matches the income of a period with the expenses incurred to earn it, ignoring the accident of when cash happened to move. It also recognises obligations and rights (payables and receivables) that the cash basis hides. The cost is that profit no longer equals cash, so a separate statement of cash flows is needed to show liquidity.

Worked example

A consultancy's cash records for the year show: cash received from clients $\$ 120,000 $; cash paid for salaries$ \ $70\,000$ ; cash paid for a two-year insurance policy $\$ 8,000 $. At the year end, clients owe a further$ \ $10\,000$ for work done, and $\$ 5,000$ of salaries for December are unpaid. Convert to accrual profit.

Step 1: Adjust income for amounts earned but not received

Cash from clients is $\$ 120,000 $, plus$ \ $10\,000$ earned but not yet received. Income earned $= 120\,000 + 10\,000 = \$ 130,000$.

Step 2: Adjust salaries for the accrual

Cash salaries $\$ 70,000 $plus$ \ $5\,000$ accrued (December owed) gives salary expense $= 70\,000 + 5\,000 = \$ 75,000$.

Step 3: Adjust insurance for the prepayment

The $\$ 8,000 $policy covers two years, so only half,$ \dfrac{8,000}{2} = \ $4\,000$ , is this year's expense. The other $\$ 4,000$ is a prepayment (asset).

Step 4: Compute accrual profit

\text{Profit} = 130\,000 - 75\,000 - 4\,000 = \$51\,000

By contrast, cash-basis profit would be $120\,000 - 70\,000 - 8\,000 = \$ 42,000 $. The accrual figure of$ \ $51\,000$ better reflects the year's performance because it counts all work done and only this year's share of costs.

Examples in context

Example 1. A magazine's annual subscriptions. A publisher receives $\$ 240,000 $in January for twelve-month subscriptions. On the cash basis all of it is income in January. On the accrual basis only$ \dfrac{240,000}{12} = \ $20\,000$ is earned each month; the unearned portion is deferred income (a liability). This prevents the publisher from reporting a full year's income before delivering eleven months of magazines.

Example 2. A start-up funded by credit sales. A new wholesaler sells $\$ 500,000$ on credit in its first quarter and reports a healthy accrual profit, yet its bank account is overdrawn because customers have not paid and it bought stock for cash. The accrual statements show it is performing well; the cash flow statement reveals the liquidity squeeze. Both are needed to understand the business, which is the practical message of this dot point.

Try this

Q1. State how the accrual basis recognises (a) income and (b) expenses. [2 marks]

Cue. (a) When earned (goods or services delivered), not when cash is received; (b) when incurred (benefit consumed), not when cash is paid.

Q2. A business pays $\$ 6,000$ rent covering the period ending three months after the year end. How much is this year's expense and what is the rest? [3 marks]

Cue. If $\$ 6,000 $covers fifteen months, then twelve months belong to this year. If instead it covers twelve months with three falling next year, only nine months ($ \tfrac{9}{12} \times 6,000 = \ $4\,500$ ) is this year's expense and $\$ 1,500$ is a prepayment; state your assumption and treat the future portion as a prepaid asset.

Q3. Explain why depreciation is consistent with the accrual basis. [3 marks]

Cue. The cost of a non-current asset is spread over the periods that benefit from its use, matching the cost to the income it helps earn, rather than expensing the whole cash outflow when the asset is bought.

Exam-style practice questions

Practice questions written in the style of SEAB exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.

Original6 marksIn its first year a business receives

\

90\,000

cash from customers and pays

60\,000

cash for expenses. At the year end, customers still owe

\

15\,000

for goods delivered, and

8\,000

of expenses incurred remain unpaid. (a) Calculate cash-basis profit. (b) Calculate accrual-basis profit. (c) Explain which is the better measure of performance.

Show worked answer →

(a) Cash-basis profit $=$ cash received $-$ cash paid $= 90\,000 - 60\,000 = \$ 30,000$.

(b) Accrual basis recognises income earned and expenses incurred, regardless of cash.

Income earned $= 90\,000 + 15\,000 \ (\text{owed by customers}) = \$ 105,000$.

Expenses incurred $= 60\,000 + 8\,000 \ (\text{accrued}) = \$ 68,000$.

Accrual profit $= 105\,000 - 68\,000 = \$ 37,000$.

(c) The accrual figure is the better measure of performance because it matches the income earned in the year with the expenses incurred to earn it, regardless of when cash moved. The cash figure ignores the $\$ 15,000 $earned but not yet collected and the$ \ $8\,000$ owed but not yet paid, so it misstates how the business actually performed.

Markers reward both profit calculations, correct treatment of the receivable and accrual, and the matching argument for the accrual basis.

Original5 marksExplain, with a numerical illustration, how a profitable business measured on the accrual basis could still run short of cash.

Show worked answer →

Accrual profit recognises income when earned, even if customers have not paid, and excludes capital spending. A business can therefore be profitable yet cash-poor.

Illustration: a firm makes credit sales of $\$ 100,000 $(all unpaid at year end) and incurs cash expenses of$ \ $40\,000$ , so accrual profit is $100\,000 - 40\,000 = \$ 60,000 $. But its cash position fell by$ \ $40\,000$ because no customer cash has arrived while expenses were paid in cash. If it also bought equipment for $\$ 20,000 $cash, it is$ \ $60\,000$ worse off in cash despite the $\$ 60,000$ accrual profit.

The reasons are timing differences (income earned but uncollected, tying up cash in receivables) and the fact that capital expenditure reduces cash but is not an expense. This is why a statement of cash flows is needed alongside accrual profit.

Markers reward a clear numerical contrast between accrual profit and cash movement, the receivables timing point, and the capital-expenditure point.