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Basis of Accounting

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  • Last Updated : 02 Aug, 2022
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The Basis of Accounting describes the method by which the financial transactions and activities are accounted for and reported in the books of accounts to determine the profit or loss of any company. Profit earned or loss incurred by the business can be determined either by Cash Basis of Accounting or Accrual Basis of Accounting.

Cash Basis of Accounting:

The system in which the transactions are recorded on the basis of actual receipt or payment in cash is called the Cash Basis of Accounting. This means that the income is recorded when cash is received and expenses are recorded when cash is paid. It doesn’t matter whether the amount which is received or paid belongs to the past, present or future year. Therefore, there is no possibility to record the credit transactions. Outstanding expenses and Accrued incomes are not recorded under the cash basis of accounting. Receipt and Payment Account prepared in the case of Not-for-Profit Organisations is an example of accounting on a cash basis. It is also called the Receipts basis of Accounting.

Key points of Cash basis of accounting:

  • The accounting entries are only made when the actual payment or receipt has been made in cash.
  • Credit transactions are not recorded in this method.
  • Outstanding expenses and Accrued incomes are not recorded under this.
  • Profit is the excess of receipts over cash payments.
  • The cash payment in excess of the receipts is a loss.

Merits of Cash Basis of Accounting:

1. It is a very easy and simple method.

2. The conservative attribute of many entrepreneurs is satisfied with this method.

3. The use of personal estimates and judgments is not required in this type of accounting.

4. The profit and loss of a business can be easily calculated.

5. A clear view of how much cash the business owns is known by this method.

Demerits of Cash Basis of Accounting:

1. It does not give a true perspective of a company’s profit or loss.

2. No adjustments related to outstanding expenses and accrued income is made, resulting in an incomplete view of financial statements.

3. There is more risk of account manipulation, as it does not record non-monetary items like depreciation, etc.  

4. In the Court of Law, accounts prepared on an accrual basis of accounting are not accepted as proof of evidence.

5. This method of accounting is not approved by the Companies Act 2013 and Income Tax department.

Accrual Basis of Accounting:

Accrual Basis of Accounting is a system where the transactions are recorded whenever they occur, no matter if actual cash is received or not in the case of income or actual cash is paid or not in the case of payment.  This means that the income is recorded in the accounting books when it is earned, regardless of whether it is due or received. Similarly, expenditure is recorded in the books when it is due, irrespective of being due or paid. The profit or loss for the period is the difference between the total expenses incurred and the income. This type of basis of  accounting is also called as Mercantile basis of accounting. Accrual basis of accounting is based on the concept of expiration and realisation which follows two basic accounting principles i.e. Matching Principle and Revenue Recognition Principle.

Key points of Accrual Basis of Accounting:

  1. The credit transactions are recorded in this.
  2. All the transactions whether cash is paid or not and received or not are recognised in this method.
  3. It is recognised by the Income Tax department and the Companies Act, 2013.
  4. Outstanding expenses, Income due, Income accrued and Prepaid expenses are all considered and recorded. 
  5. Matching Principle and Revenue Recognition Principle of Accounting is applied in this method of accounting.

Merits of Accrual Basis of Accounting:

1. It shows the correct figures for profit and loss for a particular period.

2. The final accounts maintained under this method, reflect a complete picture of the financial position of the company.

3. Non-cash items such as  depreciation is recorded in this method.

4. The matching principle of accounting is followed in this method, which helps to calculate the exact loss or profit for the year.

Demerits of Accrual Basis of Accounting:

1. The use of estimates and personal judgements is required in this.

2. This basis of accounting is complicated, which requires more time, skill and resources.

3. This method of accounting can lead people to misinterpret financial statements.

4. The accounting process is too lengthy.

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