What it means
Most large companies follow a recognised set of accounting rules, such as US GAAP or international financial reporting standards. These record income when it is earned and costs when they are incurred, whether or not cash has moved.
An OCBOA is a different but complete set of rules for preparing financial statements, chosen because it better suits the users of the statements. The most familiar example is the cash basis, where income is recorded when money is received and expenses are recorded when money is paid.
The tax basis prepares accounts using the same rules the business uses for its tax return. A regulatory basis follows the rules of a specific regulator, as some insurers and other regulated entities do.
Smaller businesses often choose these frameworks for practical reasons. The owner, the bank and the tax adviser may only care about cash and taxable profit, and the extra effort of full accrual accounting would add cost without adding much value.
A bank lending to a family business may be perfectly content with tax-basis accounts. The professional bodies now tend to use the phrase special purpose framework for these arrangements, but the older term remains common in practice.
Whatever the label, the statements must be clearly described, and the accountant's report must say which basis was used. Readers who assume the statements follow standard rules can be seriously misled.
The main limitation is comparability. Two businesses using different bases will show very different profit figures for the same period, particularly where big invoices are issued or paid near year end.
Anyone comparing results needs to know the basis first. Lenders and regulators decide which framework they accept.
A bank may be happy with tax-basis accounts for a small loan but insist on full standard rules above a certain amount, and a government contract may require a specific framework. Before choosing a basis, a business should ask who will rely on the statements and what they expect.
In practice
Real-world examples.
Example
A family-owned plumbing company prepares simple accounts on the cash basis for its bank. The owner records income when customers pay and costs when she pays suppliers. The statements are clearly labelled, and the bank is comfortable with them for a small credit line.
Example
A small partnership prepares its accounts on the tax basis so that the profit in the statements matches the profit reported in its tax return. The accountant adds a note explaining where the figures differ from standard rules. The partners use the figures to plan their personal tax payments and to agree how profits are shared.
Example
A regulated insurance company prepares statements using rules set by its regulator, which are designed to test its ability to pay claims. These statements differ from those given to shareholders, who receive standard financial statements as well. The finance team keeps a reconciliation showing how the two sets of figures link.
Formula
Calculation
Accrual-basis revenue = amounts invoiced in the period
Cash-basis revenue = cash received in the period
Difference = accrual revenue - cash revenue = increase in amounts owed by customers
A consulting firm invoices $500,000 of work during the year but collects only $420,000 by the year end. On the accrual basis its revenue is $500,000, and on the cash basis its revenue is $420,000. The difference of 500,000 - 420,000 = $80,000 is the increase in unpaid customer invoices.Case study
Seen in the real world.
Pinecrest Design Studio is a fictional design firm, and this story is illustrative. The owner used cash-basis accounts for years and was proud that profit looked strong, with $310,000 recorded for the year.
When she applied for a larger loan, the bank asked for accrual accounts. The accountant found that $95,000 of work had been completed but not yet invoiced or paid, and that $60,000 of supplier bills were unpaid at year end.
On the accrual basis, profit was 310,000 + 95,000 - 60,000 = $345,000, which was higher than the cash figure. The illustrative lesson is that the choice of basis changes the reported result, and a lender may well ask for the one that best reflects the business's true performance.
Watch out
Common mistakes.
- Assuming that cash-basis profit is the same as accrual-basis profit, when timing differences can make them diverge widely.
- Leaving out the label that states which basis was used, which can mislead readers who assume standard rules.
- Using a simple basis for a growing business that borrows or raises capital, when lenders and investors usually expect standard rules.
Questions
People also ask.
Is OCBOA allowed for audits?
Yes, an auditor can report on statements prepared under such a framework, provided the basis is clearly disclosed and acceptable to the users.
Which is better, cash or accrual?
Accrual gives a truer picture of performance, while cash is simpler and shows cash flow directly, so the right choice depends on who will read the accounts.
Is OCBOA still the official term?
Professional bodies now commonly speak of special purpose frameworks, but the older term is still understood.
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