Accountancy · Ch 2 — Theory Base of Accounting
Basis of Accounting
Basis of Accounting
The Core Idea: When Do We Record?
The entire logic of accounting rests on when you decide to recognise a transaction. Do you record it the moment cash changes hands, or do you record it the moment the transaction becomes due — regardless of whether cash has moved? That choice is the basis of accounting. It determines how you measure profit, how you value assets and liabilities, and whether your books reflect the economic reality of the period or just its cash flow.
The textbook identifies two approaches: the Cash Basis and the Accrual Basis. They differ fundamentally on the timing of revenue and cost recognition.
Cash Basis of Accounting
Under the cash basis, you make entries only when cash is actually received or paid. The moment a sale is made on credit or a bill becomes payable is irrelevant — nothing is recorded until the money physically arrives or leaves.
Example from the textbook: Office rent for December 2014 is paid in January 2015. Under cash basis, this rent is recorded in January 2015, not in December 2014. Similarly, a credit sale made in January 2015 is not recorded in January; it is recorded only in April 2015 when the payment is finally received.
Consequence for profit calculation: Profit under this system is simply the difference between cash receipts and cash disbursements for a given period. It is not based on when the transaction happened.
Why this is a problem: This method is incompatible with the matching principle, which requires that the revenue of a period be matched with the costs incurred to earn that revenue in the same period. Under cash basis, you might record revenue in one period and the related expense in a completely different period, giving a distorted picture of performance.
A common mistake is to think cash basis is 'wrong'. It is not wrong — it is simple and used by small businesses or professionals (e.g., doctors, lawyers) who do not need to match revenues and expenses. But for most organisations that need to show true profitability, it is inappropriate.
Accrual Basis of Accounting
Under the accrual basis, revenues and costs are recognised in the period in which they occur, not when they are paid. The key distinction is between:
- Receipt of cash vs. the right to receive cash (revenue earned)
- Payment of cash vs. the legal obligation to pay cash (expense incurred)
So, a credit sale is recorded as revenue the moment the sale is made, even if cash will come later. An expense like rent is recorded in the period it is due, even if paid later.
Why this is better: This basis is appropriate for calculating true profit because expenses are matched against the revenue they helped generate in the same period. The textbook gives the example of raw material consumed being matched against the cost of goods sold — the expense of raw materials is recognised when the goods are sold, not when the raw materials were paid for.
The accrual basis is the foundation of modern accounting. It is required under Generally Accepted Accounting Principles (GAAP) and by the Companies Act for most businesses. It gives a more realistic view of financial performance and position.
Summary of the Two Bases
| Feature | Cash Basis | Accrual Basis |
|---|---|---|
| When is revenue recorded? | When cash is received | When the right to receive cash arises (sale made) |
| When is an expense recorded? | When cash is paid | When the obligation to pay arises (expense incurred) |
| Basis of profit calculation | Cash receipts minus cash payments | Revenue earned minus expenses incurred in the same period |
| Compatibility with matching principle | Incompatible | Compatible |
| Suitability | Small businesses, professionals | Most organisations, required by law for larger entities |
The Accounting Treatment: A Practical Illustration
To see the difference clearly, consider a simple transaction: Goods sold on credit for ₹10,000 on 15th March 2025. Payment received on 10th April 2025.
Under Cash Basis:
- 15th March 2025: No entry. The sale is not recorded because no cash has been received.
- 10th April 2025: Cash A/c Dr. ₹10,000 To Sales A/c ₹10,000 (Being sale recorded on receipt of cash) …