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Basis Of Accounting

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    Sukhbinder S

    • Durgapur
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Cash Basis & Accrual Basis of Accounting.

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    Basis of Accounting 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. Cash Accounting Cash accounting is the simpler of the two. When you practice cash accounting, you record revenue when you receive cash -- and only when you receive cash. You could do a job for someone in May, but if that customer doesn't pay until September, then you wouldn't record the revenue until September. Similarly, you record an expense only when you pay cash. If you buy goods for your inventory in March but don't sell them until November, the expense gets reported in March. Cash accounting is the most popular method among small business owners, since it doesn't require any real accounting training, and it pretty much matches the way people handle their own checkbook. Cash Disadvantages The biggest problem with cash accounting is that it produces a picture of revenue and expenses that may be radically at odds with your actual business activity. Imagine a company that does a lot of seasonal business in November and December. Such a company might stock up on inventory (and incur expenses) in early fall. Cash payment might not come in until after the holidays, in January. The company's actual busiest months of the year, then, might show little in
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    the way of revenue and expenses. Another downside to cash accounting is that the tax code doesn't allow it for any business set up as a corporation, any business with more than $5 million a year in sales or any business that maintains inventory and has more than $1 million a year in sales. You could literally "outgrow" the cash method. Accrual Accounting The accrual method of accounting is designed to more accurately reflect business activity. You record revenue whenever you earn it, not when you receive the cash. Do a job in May, record the revenue in May -- even if the customer doesn't pay till September. Meanwhile, you record expenses when you incur them, not when you shell out cash. And expenses get matched to the revenue they produce. If you buy goods for inventory in March and don't sell them till November, then you record the expense in November, so you can match them to the revenue produced by the sale. Accrual Disadvantages Compared with cash accounting, the accrual method is quite complicated. The rules on "revenue recognition" require you to claim revenue you haven't seen and report expenses you haven't yet paid, and there are other rules for money you receive before you've earned it and for prepaid expenses. You have to estimate and report as an expense the cost of bad debts before they even occur, and many, many other things that run counter to the cash-in, cash-out mind-set that many small business people are accustomed to. Additionally, accrual accounting can produce a picture of revenue and expenses drastically different from your actual cash flow. Your books can show a torrent of revenue with no cash to show for it (or to pay your bills with).


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