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Basis of Accounting

The method used to record revenues and expenses in a company's financial statements is known as the basis of accounting. There are two main techniques that are most frequently discussed when a business discusses the basis of accounting it employs.

Types of Basis of Accounting

1. Cash Basis of Accounting

According to the cash basis of accounting, a company records income when money is received and expenses when it pays bills. Smaller organizations frequently employ this method of transaction tracking because it is the simplest.

2. Accrual Basis of Accounting

According to the accrual foundation of accounting, a company records revenue as it is earned and expenses as they are incurred. This strategy necessitates a deeper understanding of accounting because accruals must be documented on a consistent basis. Because auditors won't make a determination based on financial statements prepared using any other basis of accounting, businesses who want their financial statements audited must use the accrual basis of accounting.

Modified Cash Basis of Accounting

The modified cash basis of accounting is a variant of these two methods. This idea is most like the cash basis, with the exception that longer-term assets are also recorded with accruals, resulting in the appearance of fixed assets and loans on the balance sheet. This concept better represents the financial condition of a business than does the cash basis of accounting.

The industries that use cash accounting the most frequently include:

  • Partnerships and sole proprietorships, as these types of ownership are exempt from the requirement to publish their financial records.
  • Companies that employ single-entry accounting rather than double-entry accounting
  • Companies with fewer employees and transactions
  • Businesses with no inventory
  • Firms who don’t sell or buy on credit

Disclosure of the Basis of Accounting

When a company distributes its financial statements to third parties, the footnotes usually include a disclosure of the foundation of accounting that was utilized. Since a change in the basis of accounting may have an immediate impact on the financial results and financial position of a corporation, it may be a significant disclosure that is of great importance to those who use financial statements.

Key Takeaways

To recap, here are the main points we’ve covered:

  • The timing options for recording financial events are referred to as the basis of accounting.
  • The two primary bases for accounting are cash basis and accrual basis.
  • Cash basis documents financial transactions as they occur, whereas accrual basis records transactions as they take place, whether any cash has been received or paid.
  • Public companies and companies with annual sales of over $25 million are required by law to utilize accrual accounting. On the other hand, small enterprises are allowed to select their own foundation.
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