The basis of accounting refers to the methodology under which revenues and expenses are recognized in the financial statements of a business. When an organization refers to the basis of accounting that it uses, two primary methodologies are most likely to be mentioned:
- Cash basis of accounting. Under this basis of accounting, a business recognizes revenue when cash is received, and expenses when bills are paid. This is the easiest approach to recording transactions, and is widely used by smaller businesses.
- Accrual basis of accounting. Under this basis of accounting, a business recognizes revenue when earned and expenses when expenditures are consumed. This approach requires a greater knowledge of accounting, since accruals must be recorded at regular intervals. If a business wants to have its financial statements audited, it must use the accrual basis of accounting, since auditors will not pass judgment on financial statements prepared using any other basis of accounting.
A variation on these two approaches is the modified cash basis of accounting. This concept is most similar to the cash basis, except that longer-term assets are also recorded with accruals, so that fixed assets and loans will appear on the balance sheet. This concept better represents the financial condition of a business than does the cash basis of accounting.
The basis of accounting being used is typically listed as a disclosure in the footnotes that a business releases to outside parties as part of its financial statements. A change in the basis of accounting can be a major disclosure that would be of considerable interest to the users of financial statements, since this can have an immediate impact on the financial results and financial position of a business.