Basis
of Accounting
Businesses have different
ways of accounting for their financial activities. These ways are
called the "basis of accounting". There are two types of basis of
accounting a business can use:
Cash Basis
Under the cash basis of
accounting, a business records revenue only when cash is received
and records expenses only when cash is disbursed or paid. In other
words, if you are using a "cash basis", your financial statement only
shows actual cash which the business has received and not what is
due to the business in the future. Similarly, the cash basis only
shows expenses you have actually paid and not what you owe.
The cash basis of accounting
is used by small businesses and service businesses of all sizes. A
business that has inventory cannot use the cash basis of accounting
and must use the accrual basis of accounting.
Accrual Basis
Under the accrual basis
of accounting, a business records revenue when the sale is made and
records expenses as they are incurred. Therefore, when a customer
says "yes" and the product or service is delivered, the dollar amount
of the sale will appear on the financial statement of the business,
even if the customer has not yet paid. Business expenses will appear
on the financial statements, even if they have not yet been paid.
The accrual basis of accounting
is generally used by larger businesses and by those businesses that
are capital-intensive, such as construction contractors and manufacturers.
The accrual basis of accounting is required to be used by all businesses
that carry inventory to give a more accurate financial picture of
the business.
The basis of accounting
you select alter your reported level of income and expenses for the
business. That means it will change the amount of income taxes your
business pays.
Understanding the difference
between the two basis of accounting involves understanding the treatment
of various activities under each different basis. The following example
will help to illustrate some of the differences.
An example
Using information from
the Best Company, a hypothetical business, will help to illustrate
the difference between the basis of accounting.
The Best Company
Assumptions:
|
Cash sales
|
$400
|
|
Collections on
accounts
|
$600
|
|
Sales on account
|
$800
|
|
Proceeds on equipment
sale
|
$100
|
|
Interest income
received
|
$100
|
|
Cash operating
expenses
|
$200
|
|
Expenses paid on
accounts
|
$500
|
|
Depreciation expense
|
$100
|
|
Expenses charged
on account
|
$600
|
|
Interest expense
paid
|
$100
|
|
Income taxes paid
|
$100
|
For purposes of this example,
the proceeds on equipment sale equals the gain on the equipment sale;
interest income and interest expense equals the amount of interest
income received and interest expense paid; and income tax expense
equals the amount of income taxes paid. The example also assumes that
there was no change in inventory during the period.
Best Company
|
The income statement
under the Cash Basis of accounting follows:
|
The income statement
under the Accrual Basis of accounting follows:
|
|
|
Cash sales
|
$400
|
|
Collections
on account
|
600
_____
|
|
Total income
|
1,000
|
|
|
|
Cash operating
expenses
|
200
|
|
Depreciation
expense
|
100
|
|
Expenses paid
on account
|
500
_____
|
|
Total expenses
|
900
|
|
|
|
Operating income
|
300
|
|
Interest income
received
|
100
|
|
Proceeds on
equip. sale
|
100
|
|
Interest expense
paid
|
(100)
_____
|
|
Income before
taxes
|
400
|
|
Income taxes
paid
|
100
____
|
|
Net income
|
$300
|
|
|
Cash sales
|
$400
|
|
Sales on account
|
800
____
|
|
Total income
|
1,200
|
|
|
|
Cash operating
expenses
|
200
|
|
Depreciation
expense
|
100
|
|
Expenses charged
on account
|
600
____
|
|
Total expenses
|
900
|
|
|
|
Operating income
|
300
|
|
Interest income
received
|
100
|
|
Proceeds on
equip. sale
|
100
|
|
Interest expense
paid
|
(100)
____
|
|
Income before
taxes
|
400
|
|
Income taxes
paid
|
100
____
|
|
Net income
|
$300
|
|
Best Company would report
$200 more in revenue and $100 more in net income using the accrual
basis of accounting than they would using the cash basis of accounting,
yet the cash flow is the same for both.
The basis of accounting
selected can make a difference to the reports you make about your
business. Deciding a basis of accounting requires careful consideration
because it can be a very complicated decision. Check with your accountant
or tax adviser for guidance before selecting which basis of accounting
to use for your business.
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