Before starting to dissect the two accounting methods that we are going to talk about today, it is very important to know a specific form of information that states that, ‘If you are a corporate entity in India, there is no option but to follow Accrual based accounting as per the accounting standards and best practices. On the other hand, if you have a non corporate entity, that is, if your entity is an individual, a proprietary concern, a trust, a hindu non divided family (HUF), or a partnership firm, you do have the option of choosing the type of accounting that you want to use.
Now that we have this out of the way, let us now understand these two accounting methods in a more detailed fashion before getting into the specifics. The biggest and the main difference between the two accounting methods namely Cash Accounting and Accrual Accounting is the timing of when the Revenue and Expenses are recorded in the books of accounts.
Cash Accounting, also known as Cash-basis accounting, is an accounting method in which the payment receipts are recorded when the cash is received and expenses are recorded when the payment is actually made. The entries are done as and when the money is received or paid respectively. Since these accounts are based on the current cash transactions, your tax levied on it is pertaining to only the amount that you have received for the month.
Think of it like this. If an item worth Rs. 500 is sold in the month of June, then the entry for the same is made in the books. But in the case where the same item is given on a credit system in the month of June and payment is due in July, then the entry for such an item will be made in the month of July itself and not June.
Cash Accounting is best when you have a lot of transactions with the end consumer eg: a small stationery or grocery shop.
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The Accrual Method
Unlike the cash method, the accrual method records income when a product or service is delivered to a customer with the expectation that money will be paid in the future. Expenses of goods and services are recorded, despite no cash being paid out for those expenses. These payments/revenues are always recorded as it shows certainty that the payment of the item or service delivered will be fulfilled.
Accrual accounting, also known as the mercantile method is the accounting technique that is adopted by bigger players, majorly in the B2B business model. This helps the business in various ways including tax and auditing purposes.
How to choose the right accounting method if you are a Non-Corporate:
We already know that the Accrual method is beneficial and mandatory for large companies and corporations, especially those who have a huge number of transactions and don’t get paid on the spot.
The cash accounting method can be used by small businesses and sole proprietors with less to no inventory as it is easier for a small business owner to maintain accounts on a cash basis as it helps since they are directly in contact with customers (B2C model).
So first, identify your customers and depending on the nature of your business (corporate or non corporate), select the right method of accounting. If you are a Non Corporate entity, you may want to choose the option of cash accounting, as it looks great from a tax perspective. But it may still be a better idea, from a management perspective, to use the accrual method for internal reporting purposes.
Tax Implications on Non – Corporate assessee:
As everyone knows, it is mandatory for any business owner or individual to pay income tax on their income. The method you choose for accounting influences the amount of tax you pay. If the business owner has adopted the cash basis accounting, then he’ll have to pay tax on the income received and not earned in the particular year. Similarly, in accrual accounting, tax is paid on the income earned and not received.
PROS & CONS:
Just as a coin has two sides, these accounting methods have certain pros and cons to it. Looking at the Advantages and Disadvantages of these two, you can decide which one you would want to use.
- Recording the transactions is a lot easier, as you can do it yourself as and when you receive or pay cash.
- It helps in tracking cash flow and will give you a good indicator as to where the business stands.
- You are not taxed until and unless you have received the money in your account.
- It gives a distorted picture of your accounts as receipts for certain months of work may be recorded in some other month. For eg., You are a design company and you have submitted the designs to a client in May, but the payment came in June and July, so you will have a wrong picture of your business and how much you made in a particular month.
- It becomes difficult to ascertain your monthly profits as you may pay rent for a quarter or half year and may not record it every month.
- Tracking Accounts payable and receivable becomes a huge hassle, as you will have to maintain two different sheets or processes for recording them.
- It helps to give a better understanding of your accounts as it provides you much more accurate picture of your accounts.
- Since on an accrual basis, income earned, rather than income received is taken into consideration, it gives a clear picture of your income and expenses. For eg, even if you receive the payment in April, it will still be considered as your income in the month of March.
- Accrual accounting is perceived as a more precise measure of a company’s productivity and growth.
- In accrual accounting, one of the major disadvantages is that you are always being taxed for the income you still have not received.
- Another huge drawback is that it does a very poor job of keeping track of your cash. For Eg, if you’re running a contracting company and completing jobs on a daily basis, you can record the revenue upon completion of the job, even if you haven’t yet collected the cash. In case of delayed payment from your customers, you may face a high amount of revenue but have little cash.
- Since the accrual system takes into account the money which is yet to be received, there will always be certain discrepancies between the bank/cash account and your books. The figures might differ and at times may create confusion to keep a track of payments.
TIP: While using the accrual accounting method is to monitor cash flow on a weekly or fortnightly basis to know and keep a check on the cash available.
In order to give you a better understanding, let’s take an example where we test both the methods on the same month and see what happens after:
For instance, let us assume that the following transactions take place in a month for your business.
- Received cash Rs. 4000 from a client for the services/goods delivered last month.
- Paid Rs. 500 for the bill that was received last month.
- Sent out an invoice for Rs. 3000 to the client for which the goods are delivered.
- Received a bill of Rs. 1000 for the work done this month.
On a cash basis, your profit would be Rs. 3500 (4000-500) as these would be the expenses and income received, but not earned. But on an accrual basis, your profit would be Rs.2000 ie. (3000-1000) as these are expenses and incomes which are earned but not received.
As we mentioned earlier, if you are a corporate entity, you are mandated to use accrual based accounting. Always remember that cash based accounting might look like an interesting option for all the business owners due to its various pros mentioned above, but, unfortunately, it can only be allowed in the case of individual and non corporate entities.
We hope that we have helped you make a better decision today with respect to your accounting. If you have any other queries regarding this topic or just want someone to handle it for you, feel free to reach out to us on firstname.lastname@example.org and we would be happy to help you out!