Basis of accounting refers to the set of rules and principles that govern how financial transactions and events are recorded and reported in financial statements. It provides the framework for preparing and presenting financial information in a standardized and consistent manner. The choice of basis of accounting can significantly impact the financial statements and users' understanding of an organization's financial performance and position.
There are two commonly used bases of accounting: cash basis and accrual basis.
In cash basis accounting, transactions are recorded only when cash is received or paid out. This method is straightforward and easy to understand, as it focuses solely on the flow of actual cash. However, it may not provide a complete and accurate picture of an organization's financial activities, particularly when there are significant non-cash transactions and events.
Accrual basis accounting, on the other hand, recognizes revenues when earned, and expenses when incurred, regardless of the actual cash flow. This method aims to provide a more comprehensive view of an organization's financial performance by matching revenues with the expenses incurred to generate them. Accrual basis accounting is generally considered more accurate and reliable, especially for larger and more complex businesses.
The basis of accounting chosen by an organization depends on various factors, including legal requirements, nature of business activities, industry norms, and users' needs. It is crucial for financial statements to disclose the basis of accounting used, as it helps users interpret and compare financial information across different organizations and periods.
