Basis of Accounting

Accounting is the process of identification of transactions, recording them, classifying them, analyzing them and then communicating the end results to the users of the information. Thus Accounting is a defined set of functions and these functions need to be in an appropriate manner. For the proper working of Accounting procedures the Generally Accepted Principles have been introduced.

Among those principles, there is this one principle of Revenue Recognition. Revenue Recognition states that the expenses and revenues of a business must be matched i.e. if some income is earned then the expense done for the acquirement of that income must be recognized as well.

The Revenue Recognition is the basis of accounting. It is the method by which the books of accounts are maintained. There are 2 bases by which books are maintained:

  1. Cash Basis and
  2. Accrual Basis

Cash Basis:

The cash basis of accounting is mostly followed by the small firms. The cash basis of accounting works on the basis that the transaction will be recorded in the books of accounts only when the cash has been paid or received. This is a simple method of accounting and easy to follow. They don’t give due consideration to the credit transactions. The losses are not recorded in these accounts like depreciation, amortization, bad debts etc.

Accrual Basis:

The accrual basis of accounting is followed by the large enterprises who have enough resources to carry out the credit transactions. The accrual basis states that the transactions will be recorded when they occur i.e. income will be recorded when it is earned and expense will be recorded when it incurred. Here the cash inflow or outflow is not considered and simply the occurrence of transaction is noticed. This kind of accounting system needs a deeper knowledge of Accounting and the accounts also need to be checked time to time. In case a business wants to get audited then the following of the accrual basis is necessary. Accrual Basis is followed by most of the people due to its reliability.

This concept can be better understood by using an example:

Company A follows the cash basis of Accounting. The transactions for the week were:

  • Monday: Sale on credit for $1,000.
  • Tuesday: Paid commission $20.
  • Wednesday: Purchase of goods on cash $700.
  • Thursday: Sold goods on cash $100.
  • Friday: Electricity bill of $ 150, but not paid yet.
  • Saturday: Purchase on credit for $120.

Therefore, the profit for Company A will be:

Particulars Amount ($)
Sales 100
Less: Purchase (700)
Less: Commission Paid (20)
Loss (620)

* Here only the cash transactions are taken for the calculation of profits because the company followed the cash basis of accounting.

If the company had followed the Accrual basis of Accounting, it would have considered the credit transactions too. Then the accounts will appear like this:

Particulars Amount ($)
Sales 1100
Less: Purchase (820)
Less: Commission Paid (20)
Less: Electricity Bill (150)
Profit 110

Thus we see how big a difference can the accounting basis make. In cash basis, the company was into losses whereas in actual it is earning profit. Therefore, the Accrual basis of accounting is considered to be more reliable than the cash basis system.

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Cash basis of Accounting Vs Accrual Basis of Accounting

Before studying accounts of any company it’s important to know what kind of basis do they follow for maintaining their books of accounts. The study would be incomplete if the books are maintained on a Cash Basis because of the missing Credit Transactions.

The contrast between cash and accrual basis has been drawn below:

Basis Cash basis of Accounting Accrual Basis of Accounting
Meaning It means that the transactions are recorded in the books of accounts on the basis of the receipt or payment of cash. It is recorded when cash is paid as the salary to the employees and as a payment to suppliers. It means that the transaction is recorded when the occurrence of the transaction takes place which means that it records the transaction when the expense is incurred and the income is earned. It does not wait for the payment or the income to be realized in cash.
Applications It is generally applied in the small firms where the amount of investment is not high and they do not require any audits to be done. It is generally followed by the businesses who are large in size and do number of transactions on credit basis.
Reliability The cash basis of accounting is less reliable due to the ignorance of credit transactions. The accrual basis is more reliable than the cash accounting because it records every aspect of transaction.
Taxing and Auditing The business cannot get audit done if it follows the cash basis of accounting. The business can still use the Cash basis for the payment of the tax. If the business has to pay tax and get its audit done, then it is supposed to follow the accrual basis of accounting. For auditing each and every minute detail needs to be scrutinized.
Dimension Cash basis is a narrow method. Accrual basis is a broader method as it covers the cash basis also.
Revenue Recognition Principle The Revenue Recognition Principle is violated at times as the transaction is recorded only on the time when the cash inflows or outflows take place whereas the Revenue Recognition stresses on recording the income and expense to the period it relates. The Revenue Recognition Principle is followed in the Accrual Basis of Accounting.

Accrual basis of accounting lays down some requirements that must be met if the transaction is to be recorded in the books of accounts. These are:

1. The company must have provided the complete services or delivered the goods for which the payment has to be received. There should be no uncertainty regarding the transaction being done and there must not be any speculation about the returning of goods.

2. The price of the goods or services must have been consented upon by both the buyer and the seller and their must not be any doubt about that. Such a transaction is done in a good faith.

Concept of Modified Cash of Basis Accounting:

Many business firms find it difficult to follow the Accrual basis of accounting due to its complexity and the wideness. It requires in depth analysis of transactions and good knowledge of accounting. On the other hand they cannot even follow Cash basis of accounting due to its continuous failure in drawing reliable results.

This is why, a new basis of accounting has been introduced. It is the Modified Cash Basis of Accounting. It is a hybrid system which consists of both Accrual as well as Cash basis of accounting. It has simplified the manner of recording the transactions for the business owners.

This method works in the following manner:

  1. Following of Cash Basis for the short-term transactions such as expenses, purchases, sales, commission etc.
  2. Following Accrual Basis of Accounting for the long-term transactions such as buying of assets, applying depreciation and Amortization.

Thus the modified cash basis is useful in mitigating the short comings of both the other basis. This also serves as a reliable source of collecting and compiling information.

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