The basis of accounting signifies the methodology under which business earnings and costs are acknowledged in the financial statements.
When an business enterprise refers to the basis of accounting which it uses, two most important methodologies are likely to be reviewed:
(I) Cash Basis of Accounting
Based on the cash basis of accounting, the earnings and expenses which are received or paid in cash are taken into consideration.
The primary difference between the income and expenses is processed as profit or Loss of the business. Transactions of non-cash (credit transactions) are usually not recorded under this system.
This method of accounting is mostly restricted to practitioners such as legal professional, doctor, chartered accountants, brokers, engineers and so on.
The accounting course of action under this method is very easy to comprehend as well as simple to function. However it has got some constraints.
Business concerns where both cash and credit systems are put into practice. This system of accounting is not appropriate. Simply no such adjustment entries are feasible concerning the outstandings, prepaid or received in advance.
(II) Accrual Basis of Accounting
Based on the above basis of accounting, the earnings and expenditures are credited and debited respectively to the period of time to which they relate, regardless of whether cash has been received or paid.
Right before figuring out the actual profit earned or loss suffered, items relating to outstandings, prepaid and received in advances are adjusted thoroughly.
This method of accounting is practiced in almost all business carrying on business on large scales.