Basis of accounting

The basis of accounting refers to the method used to recognize and record financial transactions in the accounting system. There are three main basis of accounting:

1. Cash basis

2. Accrual basis

3. Hybrid or mixed basis

1. Cash basis of accounting

Under the cash basis of accounting actual cash receipts and actual cash payments are recorded.  Credit transactions are not recorded at all and are ignored till the cash is actually received or paid. Income is merely the difference between the cash receipts and cash payments. The Receipts and Payments Account prepared in case of non-trading concerns such as a charitable situation, institution, a club, a school, a college etc. and professional men like lawyer, doctor, a charted accountant etc. can be cited as the best example of cash basis.

 Advantages

The main advantages of cash basis of accounting are:

i. Cash basis of accounting has considerable appeal to many people because it is so simple, appears to be so realistic, is verifiable and satisfies the conservative instinct.

ii. This approach is more objective as very few estimates and judgments are required.

iii. This basis of accounting is suitable for those enterprises where most of the transactions are on cash basis.

Disadvantages

The main disadvantages of cash basis of accounting are:

i. Cash basis of accounting does not give a true and fair view of profit and loss and financial position of the enterprise because it ignores outstanding and prepaid expenses and a crude income and income receiving advance.

ii. This approach does not follow matching principle of accounting does not distinguish between capital and revenue items and as a result there is no consistency in the profits of the two years.

iii. In this approach actual cash inflows and outflows are considered, there is great possibility of profit manipulation e.g. payments may be delayed or proposed similarly incomes may be postponed or collected early.

Example Scenario

Let’s illustrate the cash basis of accounting using an example.

Consider a small business, “XYZ Services,” operating in India. The business has the following transactions in the month of July:

1. July 5: Completed a consulting project and invoiced the client for ₹50,000, but the client will pay in August.

2. July 10: Paid ₹5,000 for office supplies.

3. July 15: Received ₹30,000 in cash from a client for a consulting project completed in June.

4. July 20: Paid ₹20,000 for rent for July.

5. July 25: Completed another consulting project and received ₹40,000 in cash on the same day.

Cash Basis Calculation

Under the cash basis of accounting, only the transactions that involve actual cash inflows or outflows in July are recorded. Here’s how each transaction is treated:

1. July 5 – Invoiced ₹50,000 (no cash received):

• Not recorded because no cash was received in July. The cash basis only records transactions when cash changes hands.

2. July 10 – Paid ₹5,000 for office supplies:

• Expense Recorded: ₹5,000 for office supplies.
• The expense is recorded in July because cash was paid out.

3. July 15 – Received ₹30,000 for a project completed in June:

• Revenue Recorded: ₹30,000.
• The revenue is recorded in July because cash was received, even though the service was provided in June.

4. July 20 – Paid ₹20,000 for July rent:

• Expense Recorded: ₹20,000 for rent.
• The expense is recorded in July because the rent payment was made in July.

5. July 25 – Completed a project and received ₹40,000:

• Revenue Recorded: ₹40,000.
• The revenue is recorded in July because cash was received on the same day the service was provided.

Summary of Cash Basis Entries for July

• Total Revenue:
  • ₹30,000 (July 15) + ₹40,000 (July 25) = ₹70,000
• Total Expenses:
  • ₹5,000 (July 10) + ₹20,000 (July 20) = ₹25,000

Net Income for July (Cash Basis)

• Net Income = Total Revenue – Total Expenses
• Net Income = ₹70,000 – ₹25,000 = ₹45,000

2. Accrual basis of accounting

Keeping in view the disadvantages of the cash basis of accounting the accrual basis of accounting has been developed by accountants. In accounting every cash receipt cannot be treated income for determining the true profit of the accounting entity of the period. Accrual basis of accounting rejects the circumstances of receipt or payment of cash as criteria for associating either income or expense with a period. Rather this basis of accounting is based on concept of realization and expiration and follows two basic accounting principles viz. the revenue recognition and the matching principle. On the accrual basis of accounting the income whether received or not but has been earned or accrued during the period forms past of the total income of that period for example sales made on credit will be included in the total sales of the period irrespective of the fact when cash is actually realized. Thus under accrual basis of accounting net income for a period is the result of matching of revenue realized in the period and costs expired during the period.

Advantages

The main advantages of accrual basis of accounting are:

i. Accrual basis of accounting is preferred by accountants as it is more scientific as compared to cash basis of accounting.

ii.  The basis of accounting gives a complete picture of the financial transactions of the business as it makes a record of all transactions relating to a period and takes into account adjustments like outstanding expenses, prepaid expenses, income received in advance and income earned but not received etc.

iii. This system discloses correct profit or loss for a particular period and also exhibit true financial position of the business on a particular day.

iv. Accrual basis of accounting has wide acceptability as the Company’s Act 1988 has amended section 209 of the Company’s Act 1956 with effect from 15 June, 1988 requiring all companies to maintain their accounts on accrual basis of accounting so that fairest possible periodic net income and the financial position may be reported to the public.

Disadvantages

The main disadvantages of accrual basis of accounting are:

i. This system is not as simple as cash pieces of accounting

ii. A quick appraisal of the profit or loss is not possible as a lot of adjustments are required for finding the true financial position of the business.

iii. This basis of accounting is too elaborate.

Example Scenario

Let’s go through an example of accrual basis accounting

Consider the same small business, “XYZ Services,” operating in India. The business has the following transactions in the month of July:

1. July 5: Completed a consulting project and invoiced the client for ₹50,000. The client will pay in August.
2. July 10: Paid ₹5,000 for office supplies.
3. July 15: Received ₹30,000 in cash from a client for a consulting project completed in June.
4. July 20: Paid ₹20,000 for rent for July.
5. July 25: Completed another consulting project and received ₹40,000 in cash on the same day.

Accrual Basis Calculation

Under the accrual basis of accounting, revenues and expenses are recognized when they are earned or incurred, regardless of when cash is received or paid. Here’s how each transaction is treated:

1. July 5 – Invoiced ₹50,000 for a consulting project:

• Revenue Recorded: ₹50,000.
• The revenue is recorded in July because the service was provided in July, even though the cash will be received in August.

2. July 10 – Paid ₹5,000 for office supplies:

• Expense Recorded: ₹5,000.
• The expense is recorded in July because the supplies were purchased and used in July.

3. July 15 – Received ₹30,000 for a project completed in June:

• No Revenue Recorded in July.
• The revenue was already recorded in June when the service was provided, so no additional entry is made in July. This transaction affects cash but not revenue in July under the accrual basis.

4. July 20 – Paid ₹20,000 for July rent:

• Expense Recorded: ₹20,000.
• The expense is recorded in July because it relates to July’s rent.

5. July 25 – Completed a project and received ₹40,000 in cash:

• Revenue Recorded: ₹40,000.
• The revenue is recorded in July because the service was provided in July, and cash was received on the same day.

Summary of Accrual Basis Entries for July

• Total Revenue:
  • ₹50,000 (July 5) + ₹40,000 (July 25) = ₹90,000
• Total Expenses:
  • ₹5,000 (July 10) + ₹20,000 (July 20) = ₹25,000

Net Income for July (Accrual Basis)

• Net Income = Total Revenue – Total Expenses
• Net Income = ₹90,000 – ₹25,000 = ₹65,000

3. Hybrid or Mixed basis of accounting

Cash basis of accounting is by far the simplex system whereas the accrual basis of accounting is scientific and reliable. So accountants have tried to club these advantages of the two systems and have come up with mixed or hybrid basis of accounting. Under mixed basis of accounting both cash basis and accrual basis are followed. Incomes are recorded on cash basis whereas expenses are taken on accrual basis. The net income is ascertained by matching expenses on accrual basis with income on cash basis. This is the most conservative basis of ascertaining income because all possible expenses relating to the period whether actually paid or not are considered whereas income only received with cash is taken into consideration.

Advantages

i. Hybrid basis of accounting allows customization of accounting methods for different transactions. For example, using cash basis for revenue ensures that taxes are only paid on received income, while using accrual basis for expenses provides a more accurate picture of obligations.

ii. It improves Cash Flow Management as it aligns revenue recognition with actual cash inflows, aiding in better cash management.

iii. Hybrid basis of accounting matches expenses with the period they are incurred, leading to more accurate profit calculation.

iv. The hybrid approach can be beneficial for tax planning, as it may allow businesses to defer income recognition until cash is actually received, potentially reducing tax liabilities in a given period.

v. Small businesses that may find full accrual accounting too complex can use the hybrid approach to maintain simplicity in some areas while gaining accuracy in others. It is easier to manage for small businesses by maintaining simplicity in some areas while improving accuracy in others.

Disadvantages 

i. Because income and expenses are recorded on different bases, financial statements may lack consistency, making it harder to compare financial performance over time or with other businesses.

ii. Managing two different accounting methods for different transactions can be more complex than using a single method, requiring more careful record-keeping and potentially leading to confusion or errors.

iii. The hybrid basis may not be accepted for all types of financial reporting or by all regulatory authorities. For instance, publicly traded companies are generally required to use full accrual accounting.

iv. The flexibility of the hybrid method can allow for some level of income or expense manipulation, as businesses might delay or accelerate the recognition of certain transactions to meet financial targets or tax objectives.

v. Financial data generated from the hybrid basis may not always provide the most accurate or reliable information for decision-making, especially for stakeholders who are used to fully accrual-based financial statements.

Example Scenario

To illustrate the hybrid or mixed basis of accounting, we’ll use the same business, “XYZ Services,” and apply a hybrid approach. In this example, the business uses:

• Cash Basis for recognizing income from services.
• Accrual Basis for recording expenses.

Here are the transactions for July:

1. July 5: Completed a consulting project and invoiced the client for ₹50,000. The client will pay in August.

2. July 10: Paid ₹5,000 for office supplies.

3. July 15: Received ₹30,000 in cash from a client for a consulting project completed in June.

4. July 20: Paid ₹20,000 for rent for July.

5. July 25: Completed another consulting project and received ₹40,000 in cash on the same day.

Hybrid Basis Calculation

Under the hybrid basis of accounting:

• Revenue is recognized using the cash basis (only when cash is received).
• Expenses are recognized using the accrual basis (when they are incurred).

Here’s how each transaction is treated:

1. July 5 – Invoiced ₹50,000 for a consulting project:

1. • No Revenue Recorded in July because the cash has not been received. Revenue will be recorded when the payment is received in August (cash basis).

2. July 10 – Paid ₹5,000 for office supplies:

• Expense Recorded: ₹5,000.
• The expense is recorded in July because the supplies were purchased and used in July (accrual basis).

3. July 15 – Received ₹30,000 for a project completed in June:

• Revenue Recorded: ₹30,000.
• The revenue is recorded in July because cash was received, even though the service was provided in June (cash basis).

4. July 20 – Paid ₹20,000 for July rent:

• Expense Recorded: ₹20,000.
• The expense is recorded in July because it relates to July’s rent (accrual basis).

5. July 25 – Completed a project and received ₹40,000 in cash:

• Revenue Recorded: ₹40,000.
• The revenue is recorded in July because cash was received on the same day the service was provided (cash basis).

Summary of Hybrid Basis Entries for July

• Total Revenue:
  • ₹30,000 (July 15) + ₹40,000 (July 25) = ₹70,000
• Total Expenses:
  • ₹5,000 (July 10) + ₹20,000 (July 20) = ₹25,000

Net Income for July (Hybrid Basis)

• Net Income = Total Revenue – Total Expenses
• Net Income = ₹70,000 – ₹25,000 = ₹45,000

The choice between cash, accrual, and hybrid accounting depends on the size, complexity, and specific needs of the organization. The cash basis is simple and cash-flow focused but may not provide a full picture of financial health. The accrual basis is comprehensive and accurate, aligning with standard accounting practices, but is more complex. The hybrid basis offers flexibility, combining elements of both, but requires careful implementation to ensure consistency and accuracy.