What is the Basis of Accounting?
The basis of accounting is the method or principle that determines when and how revenues and expenses are recognized in the financial statements of a business.
The way accounting is done has a significant impact on how a company’s financial performance and position are measured and reported.
There are two main bases of accounting
- the cash basis and,
- the accrual basis.
Cash basis of accounting
Under this method, revenues are recognized when cash is received, and expenses are recognized when cash is paid. This means that transactions are recorded only when there is a change in the cash balance of the entity.
Free Accounting Software for Small Businesses
The cash basis of accounting is simple and easy to apply. Still, it does not reflect the economic reality of the business’s activities, as it ignores the matching principle and the revenue recognition principle.
The cash basis of accounting is not accepted by generally accepted accounting principles (GAAP) or international financial reporting standards (IFRS). Still, it may be used by some small businesses or individuals for tax or internal purposes.
Accrual basis of accounting
Under this method, revenues are recognized when they are earned, and expenses are recognized when they are incurred.
This means that transactions are recorded when there is a change in the economic resources or obligations of the business, regardless of when cash is exchanged.
The accrual basis of accounting follows the matching principle and the revenue recognition principle, which state that revenues and expenses should be matched in the same period in which they are generated and realized.
It provides a more accurate and complete picture of the company’s financial performance and position, as it reflects the economic substance of the company’s activities.
GAAP and IFRS require the accrual basis of accounting, and most businesses and organizations use it for external reporting purposes.