The basis of accounting refers to the framework or method used to determine when financial transactions are recognized and recorded in the accounting system. It defines the rules for recognizing income and expenses, shaping how financial statements reflect a business’s financial position and performance. The two primary bases of accounting are the cash basis, where transactions are recorded only when cash changes hands, and the accrual basis, where transactions are recorded when they are earned or incurred, regardless of cash flow. Choosing the appropriate basis of accounting is essential as it affects the accuracy and relevance of financial reporting, depending on the size, nature, and regulatory requirements of the organization.

• The basis of accounting describes how financial activities are recognized and reported.
• The basis of accounting refers to the framework or set of rules that an organization follows when recording, reporting, and summarizing its financial transactions and preparing financial statements.

There are two primary bases of tracking income and expenses in accounting:

Cash Base of Accounting

The cash basis of accounting is a straightforward and commonly used accounting method where financial transactions are recorded only when cash is exchanged. Under this system, income is recognized when cash is received, and expenses are recorded when payments are made, regardless of when the actual transactions occur. This approach is particularly popular among small businesses and sole proprietors due to its simplicity and ease of use. While the cash basis provides a clear view of cash flow, it may not accurately reflect the overall financial position, as it does not account for outstanding receivables or payables.

• A method / approach of recording transactions.
• It recognizes and record transactions when cash is received or paid, regardless when they occur.
• Revenues are recognized or recorded only when cash is received.
• Expenses are recognized or recorded only when cash is paid.
• So, under this method, there is no accrued / un-earned incomes and prepaid / outstanding expenses in the Balance Sheet.
• Reporting Period: transactions are reflected in the books of accounts for the period in which actual receipts or actual payments are made.

Merits of Cash Basis of Accounting

• Simplicity: cash basis is simple, easy to understand and straightforward approach of recording transactions. It simplifies bookkeeping with few receivables and payables and reduce the need for complex accounting systems making it ideal for small businesses. Consequently, its widely used by sole proprietors and small sized businesses.
• Cash Flow Management: it provides a real-time view of a company’s cash flow. It helps businesses manage their cash effectively by focusing on actual cash transactions, enabling them to assess their liquidity and make informed decisions about spending and investments.
• Tax Benefits: Some small businesses can benefit from lower taxes with the cash basis. Since revenue is only recognized when received, and expenses are recorded when paid, it can help defer taxable income. This can be advantageous for businesses with fluctuating income, allowing them to time transactions for tax optimization.

Demerits of Cash Basis of Accounting

• Non-Compliance with Accounting Standards: Accounting standards generally do not support the exclusive use of the cash basis of accounting for preparing financial statements, especially for larger businesses or those that have external reporting requirements. Accounting standards, such as GAAP or IFRS, emphasize the use of accrual accounting as the preferred method for financial reporting.
• Limited Financial Insight: it may not accurately reflect the complete picture of a business’s financial health because it ignores receivables payables or adjusting entries, which are essential for understanding overall financial position. This can make it challenging to assess profitability, assets, and liabilities accurately.
• Timing and Income Manipulation: cash basis can be manipulated by timing transactions to minimize or maximize reported income in a given year. This may not accurately represent the business’s financial performance. Such manipulation can also raise concerns about financial transparency and integrity.
• Not Conducive to Growth: As a business grows, the cash basis can become less suitable. It may not meet the financial reporting requirements of investors, lenders, or regulators, who typically prefer accrual accounting to get a more accurate view of a company’s financial performance and obligations.

Accrual / Mercantile Base of Accounting

The accrual basis of accounting is a widely used accounting method that records financial transactions when they are earned or incurred, regardless of when cash is received or paid. Under this system, revenues are recognized when they are earned, and expenses are recorded when they are incurred, providing a more accurate and comprehensive view of a business’s financial performance and position. This method is commonly used by larger organizations and businesses that need to comply with accounting standards, as it aligns financial reporting with the matching principle. While more complex than the cash basis, the accrual basis offers a clearer picture of long-term profitability and financial health.

• A method / approach of recording transactions.
• It recognizes and records transactions when they occur, regardless when cash is received or paid.
• Revenues are recognized or recorded when it’s earned, no matter when cash is received.
• Expenses are recognized or recorded when they incurred, no matter when cash is paid.
• So, under this method, there may be accrued / un-earned incomes and prepaid / outstanding expenses in the Balance Sheet.
• Reporting Period: transactions are reflected in the accounts for the period in which they occurred.
• This basis includes consideration relating to deferrals, allocations, depreciation and amortization.

Merits of Accrual Basis of Accounting

• Compliance with Accounting Standards: accrual basis is generally in compliance with accounting standards such as GAAP and IFRS. Using accrual accounting makes it easier for medium and especially large sized business to meet regulatory and financial reporting requirements and for compliance with standards.
• Accurate Financial Reporting: The accrual basis provides a more accurate representation of a company’s financial position and performance over time. It matches revenues with the expenses incurred to generate those revenues. This alignment of income and expenses provides a truer picture of profitability and financial health.
• Better Long-Term Planning: Accrual accounting helps businesses plan for the long term. It allows for better tracking of receivables and payables, making it easier to manage cash flow, anticipate future financial obligations, and make informed decisions about investments, expenditures, and financing.

Demerits of Accrual Basis of Accounting

• Complexity: accrual accounting can be more complex and time-consuming than the cash basis because it requires tracking receivables, payables, and adjusting entries. This complexity can be challenging for small businesses with limited resources.
• Cash Flow Challenges: While accrual accounting provides a more accurate financial picture, it doesn’t necessarily reflect a company’s actual cash flow. Businesses may face cash flow challenges if they record revenues before receiving cash from customers or record expenses before paying bills, which could lead to liquidity issues.
• Potential for Income Manipulation: accrual basis allows for some degree of choice in recognizing revenue and expenses. This can potentially be manipulated to influence reported income, which could raise concerns about financial transparency and integrity. Sometimes, companies may use aggressive accounting practices to meet financial goals or targets.

Modified Cash / Hybrid Base of Accounting

• A hybrid approach that combines elements of both cash and accrual basis accounting.
• In this approach, certain transactions are recorded using cash basis while others are recorded using the accrual basis. Mostly, revenues are recorded only when its earned (accrual basis) and expenses are recorded only when cash is paid out (cash basis); however, adjustments are made for expenditures of items having an economic life of more than one year such as equipment, prepaid expenses etc.
• This concept is most similar to the cash basis, except that longer-term assets are also recorded with accruals, so that fixed assets and loans will appear on the balance sheet.
• It provides a simplified yet more accurate method of financial reporting than does the cash basis of accounting. It often used by smaller businesses that want some of the advantages of accrual accounting but with simpler record-keeping without the complexity of full compliance with accounting standards.

Difference between Cash & Accrual Base of Accounting

The choice between cash basis and accrual basis accounting can have significant implications for a company’s financial statements and how it reports its financial performance. Small businesses, for simplicity, may use cash basis accounting, while larger companies typically use accrual basis accounting for its adherence to accounting standards and better reflection of economic reality.

In summary, the accrual basis of accounting is generally preferred for its ability to provide a more accurate financial picture and compliance with accounting standards. However, it comes with increased complexity and a potential for cash flow challenges and income manipulation. The choice between cash and accrual accounting should be made based on the specific needs and circumstances of the business.