In our previous post we have touched upon how to make your accounting effective. In this post we will explore ” Cash Basis Accounting vs Accrual Accounting” in detail.
The difference between cash and accrual accounting lies in the timing of when sales and purchases are recorded in your accounts.Cash accounting recognizes revenue and expenses only when money changes hands, but accrual accounting recognizes revenue when it’s earned, and expenses when they’re billed (but not paid).
Cash Basis of Accounting
Cash basis is simplest method of accounting.Revenues and expenses are accounted when they are paid.Consequently, this method does not recognize accounts receivable or payable.
This method is best suited for small businesses as it is easy to determine when the transaction has occurred.Moreover, there is no need to track receivables or payables. One has to look at the bank balances to understand the money available.
Accrual basis accounting
Accrual accounting is a method of accounting where revenues and expenses are recorded when they are earned, regardless of when the money is actually received or paid. Revenue is recorded when the delivery of the product or service is complete, rather than waiting for payment.
Accrual method is an improvement over the cash method of accounting. This provides a realistic, long term view of the business finances. A possible downside is is that accrual accounting doesn’t provide any awareness of cash flow; a business can appear to be very profitable while in reality it has empty bank accounts.Accrual basis accounting without careful monitoring of cash flow can have potentially devastating consequences.
The effect on cash flow
The method of accounting has an impact on the cash flow. Let’s look at an example of how cash and accrual accounting affect the bottom line differently.
Imagine you perform the following transactions in a month of business:
- Sent out an invoice for Rs 5,000 for service completed this month
- Received a bill for Rs 1,000 in developer fees for work done this month
- Paid Rs 75 for a bill received last month
- Received Rs 1,000 from a client for a project that was invoiced last month
The effect on cash flow
- Using the cash basis method, the profit for this month would be Rs 925 (Rs 1,000 minus Rs 25)
- Using the accrual method, the profit for this month would be Rs 4,000 (Rs 5,000 minus Rs 1,000)
Which method to Choose?
The Income Tax Act in India allows non corporate entities to maintain books of accounts under cash basis. Non corporate entities in India may include an individual, a proprietary concern, a Hindu Undivided Family (HUF), a partnership firm, a LLP, a trust, etc.A corporate entity viz public & private limited companies, LLP’s are required to maintain the books of accounts only under accrual basis.
A change in the method of accounting has to be stated in the income tax returns filed every year.