written by | April 15, 2022

A Simple Guide on the Basis of Accounting

Every business needs to manage its transactions. For that, they use accounting. Accounting has different frameworks that accountants can use, differentiating the accounting style from one another. There are two major accounting bases, which we have discussed in detail below.

Did you know?

The basis of accounting determines when a business formally calculate its sale as income.

What Is the Basis of Accounting?

Accounting is a process of record-keeping; the basis of accounting becomes the method or the framework using which the accountant makes the records. There are two methods or frameworks that can be used for accounting.

  • Cash basis accounting.
  • Accrual basis of accounting.

Also Read: Accounting Equation: Overview, Formula, and Examples

Both cash basis and accrual basis of accounting work fine. Still, they have benefits and disadvantages when selecting one to use as a basis of accounting in a business. Any business must select one or the other.

First, let's understand what these approaches are and how they work. 

Cash Basis of Accounting

The cash basis of accounting is plain and simple. You keep a record of all the income and expenses you have in your business. You record them at the time income is received and expense is paid. It is not as complex as the accrual basis and does not require as much practice and knowledge.

Example

Understand how it works with the help of an example.

Raj steelworks operates under the cash-basis accounting method.

The shop receives steel sheets from their vendor worth ₹ 5000 every Friday and is given an invoice for the amount due. Which is paid by the owner on Monday. The expense is recorded on Monday since that is when cash was transferred.

Looking at income, a customer visits Raj steelworks on Tuesday. They buy steel utensils made from sheets worth ₹ 4000, which were to be delivered the next day. Cash is paid. The business records the income on Tuesday since it was received that day.

Accrual Basis of Accounting

The accrual basis of accounting is complex and consumes more time than the cash basis of accounting. This method differs as the time of recording the income and expense are different. The accountant is supposed to record the expense when it is incurred and not when you are actually paying them. It uses a double-entry bookkeeping system, making it harder and more complex and more reliable than cash.

Example

Let’s understand this with a similar example.

Raj steelworks operates under the accrual basis accounting method. The shop receives steel sheets from their vendor worth ₹ 3000 every Thursday and is given an invoice for the amount due. Which is paid by the owner on Friday. That means the sheets received on Thursday are not paid for until Friday. The expense is recorded on Thursday since that is when the expense occurred transferred.

Difference Between Cash and Accrual Basis of Accounting

Since both the basis of accounting are not the same, let’s go over a few of the differences.

Basis

Accrual basis of accounting

Cash basis of accounting

Meaning

Whenever expenses are incurred and paid or unpaid, they should be recorded. And when the income is earned and it may be received or not.

Only record transactions in which cash is paid against expenses and received against income.

Objective

To know the cash balance in the business.

To know the profit and loss situation in the business.

Recording process

Complex process.

Simple process.

Financial statement

It shows the actual position of the business.

It does not show the actual position of the business.

Recognition

A recognised system of accounting.

Not a recognised system by law.

Level of business

It is applicable at all levels of business.

It is suitable only for very small businesses.

Accuracy

More accurate.

Less accurate.

Business transaction

All transactions are recorded.

Only cash transactions are recorded.

Should a Small Business Use Cash Basis or Accrual Basis of Accounting?

Cash and accrual basis both have their factors that influence selection for a business. However, small businesses can benefit from the cash basis of accounting more for a few listed reasons.

  • A cash basis is less expensive than an accrual basis.
  • The cash basis of accounting was designed to run a small business.
  • You have more in-hand cash at your disposal.

What Are the Various Accounting Principles?

No matter the basis of accounting a business chooses to operate with, some accounting principles need to be followed. Especially in case, the business uses an accrual basis of accounting.

A list of the basis of accounting principles are

Conservatism Principle

The conservatism principle advises accountants always to be thoughtful about recording expenses and keep the possibility of errors on the most conservative side. Meaning that at the time of recording, one must never overestimate revenues and underestimate expenses.

Consistency Principle

There should be a consistent application of all the accounting principles and rules. It maintains comparability between the financial statements.

Objectivity Principle

All the accounting records and financial statements, along with additional financial information, should be whole and free from bias. There should be minimum content that could raise an objection.

Time Period Principle

A standard time is set for reporting financial statements. It could vary from company to company.

Economic Entity Principle

Since the company or the business is an entity of its own. The accountant is advised to keep the personal transaction of the owner separate from the business. The business is considered to have a separate legal entity from its owner.

Historical Cost Principle

According to this principle, companies must record the purchase of goods, services, or any assets at the price they had to pay when they were bought. All the assets or purchased value remains on the balance sheet at that historical value and are not adjusted against the market value fluctuations.

Revenue Recognition Principle

Based on the revenue recognition principle, a company must keep a record of revenue when it is earned rather than at the point of it being collected. Meaning the revenue record will be made when the firm does an activity to generate the revenue.

Also Read: Key Features of Accounting Software and its Advantages

Matching Principle

This principle suggests that all expenses must be recorded and matched along with the revenues in the period they incurred. This principle is similar to revenue recognition and ensures that all revenue and expense are recorded on an accrual basis.

Full Disclosure Principle

This principle mandates any information that has the potential to affect any of the financial statement user's decisions about the company must be mentioned as a footnote in the financial statement. It also prevents any uninformed decisions and fraudulent activity.

Cost-Benefit Principle

The cost-benefit principle states that if, in any case, the cost of recording an event in the books of account is more than the benefit of recording the event. It is better to forgone such events.  

Going Concern Principle

A business is started to make profits. It is assumed that the business will continue to exist long enough to carry out its operation and will not end soon. Such an assumption allows the business or the company to manage the expenses better. If an accountant believes that the company is no longer in the condition to operate any further, such an assessment should be disclosed.

Materiality

This principle provides the accountant with a guideline if the said amount is insignificant. In certain conditions, it can be allowed to violate a specific principle to record that event. It can also be said that only the transactions that will create a material impact are to be recorded in the financial statement.

Reliability

The transactions recorded in the books of account should be authentic and reliable. The transactions can also have evidence supporting their occurrence.

Conclusion

The key takeaway we can have about the basis of accounting is that there are two major methods based on which a business is supposed to maintain the account.

What differentiates the cash and accrual basis of accounting is simply the timing of the recording of an event. We discussed a few differences between the cash and accrual accounting basis, ranging from the objective to ease of use. No matter the basis of accounting, once the business has chosen one of the two, it must stick with that method until the end of the business. Apart from that, a business needs to follow a few accounting principles in its bookkeeping.
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FAQs

Q: Why is it necessary to follow a certain basis of accounting?

Ans:

Having a basis of accounting provides a framework for stakeholders in a business to work efficiently with each other.

Q: Are there any more basis of accounting than cash and accrual basis?

Ans:

There are two alternatives to these: modified cash basis and modified accrual basis of accounting.

Q: What accounting principles should a business comply with?

Ans:

There are generally 14 accounting principles that a business needs to consider while maintaining its accounts.

Q: Which is more accurate and recognised between cash and accrual basis of accounting?

Ans:

The accrual basis of accounting is more accurate and recognised, but it is also more complex and expensive.

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