All companies need to decide how to account for their business transactions at the onset of their business operations. Companies can record their accounts in two ways, either in Cash or on an Accrual basis. They need to understand both these methods and decide carefully which accounting method would best suit their business needs. A company cannot change their accounting method frequently and needs to follow any one method consistently.
Cash Accounting Method
Cash accounting is the most simplified method of accounting, where the company records transactions only on receipt or payment of cash. As the company accounts for expenses and revenues only when goods and services are exchanged and money is received or paid immediately; it does not recognize any liabilities or receivables.
Under this method, companies will record sales or purchases only when the amount is realized. Small business owners and sole proprietors primarily used this method of accounting.
The advantages of cash-based accounting are:
Very convenient to use:
Cash accounting is very easy to follow as companies only need to record the inflow and outflow of funds. As there are very few transactions to record, companies do not need to maintain journals and ledgers, and they can simply record transactions every day after winding up the day’s activities.
Plan transactions and reduce taxes:
Since companies recognize every transaction only after they realize the amount, companies can easily plan and track their expenses and income. Proper planning of inflows and outflows of cash can help companies to take advantage of various taxes and reduce their tax obligations.
Cash projections on a real-time basis:
The cash required and the cash on hand can be easily calculated by simple addition and deletion, which can be done with just a calculator at any point in time.
Disadvantages of cash-based accounting are:
Does not show the actual picture:
Accounting under the cash method cannot identify payments pertaining to a particular period, as transactions are accounted for only when cash is paid or received. Thus, there may be times when the companies would either pay or receive a huge amount of money at a particular point in time, which may result from past efforts.
No receivables or payables:
The cash method does not recognize receivables and payables. However, in real-life scenarios, companies need to give time to receive payment from customers and also need time to pay off their suppliers.
Not suitable for growing businesses:
Cash accounting is only suitable for small business owners who have limited transactions. Companies that are growing have complex transactions and need to adopt accrual-based accounting.
Accrual Accounting Method
The accrual method is also known as the Mercantile basis of accounting. Under this method, companies record transactions as soon as they accrue and not when money is realized. It means that income is recorded when goods/ services are delivered and expenses are recorded as and when they are incurred.
Most businesses and professionals around the globe widely use the accrual method of accounting. It makes use of double-entry bookkeeping, where all expenses and incomes are matched regularly. The accrual method of accounting provides a better estimate of cash flows and the financial position of a company.
Advantages of the Accrual method of accounting:
Under this method, companies maintain proper books of accounts for recording every transaction. This ensures that no transaction is left unaccounted for and that all expenses and incomes are carefully recorded as per double-entry bookkeeping principles. This method makes every person accountable for using the funds of the company and limits the occurrence of errors and fraud.
The accrual method recognizes receivables and payables which enables companies to track their expenses and income carefully. It helps to monitor the company’s financial position more accurately and provides a true and fair picture of the company’s financial health.
Almost all organizations widely accept and follow this method of accounting. It complies with the GAAP and is also recognized by the Indian Companies Act, of 2013.
Disadvantages of the Accrual method of accounting:
Complicated and expensive:
This method requires the use of various accounting principles and policies to record business transactions. It requires the implementation of an accounting system, hiring an accounting and financial professional, preparing financial statements, etc. All this requires both time and money and thus it is an expensive method of accounting.
Inaccurate Short-term forecasting:
Companies record expenses and incomes as soon as they have accrued, thus, the accounts will reflect income even before it is received. This will show more income which may not be available on hand to settle the expenses and liabilities in the short term.
Which method should you select?
Both these methods have their own advantages and disadvantages, the selection of a method of accounting depends on the size, resources, and company needs. If you own a small business, have few transactions and do not want to hire an accountant, then cash-based accounting can be followed. However, if you are a medium, growing or large company and need to handle your receivables, payables, inventories, etc. then the accrual method is the best to be followed.
Companies select the cash method or accrual method in order to gain tax benefits. The Income tax in India allows non-corporate entities like individuals, partnership firms, HUFs, etc. to follow cash-based accounting. Corporate entities like private and public limited companies need to follow accrual-based accounting.
The Indian Companies Act, 2013 does not recognize cash-based accounting, it only recognizes accrual-based accounting.
Once the company has selected a particular method, it cannot be changed frequently since the change requires an elaborate process and the change has to be mentioned while filing the income tax returns each year.
Still in doubt?
If you are still not sure which method suits your business needs, you can always approach a professional or a financial service provider to clear your doubts. Diligen is one such financial service provider who can help you decide the best accounting method. They have a dedicated team of financial professionals and accountants who understand the nitty-gritty of business and advise the best course of action.
If you do not possess the skills to maintain your books on an accrual basis, Diligen can help you maintain and keep your accounts up-to-date with the accounting principles and latest accounting standards.