Bases of Accounting

There are two bases of ascertaining profit or loss, namely: (1) Cash Basis, and (2) Accrual Basis.

1. Cash Basis of Accounting : Under this system of accounting, transactions are recorded
in the books of accounts only on the receipt/ payment of cash. The income is calculated
as the excess of actual cash receipts (in respect of sale of goods, services, properties etc.)
over actual cash payments (regarding purchase of goods, expenses, rent, electricity,
salaries etc.)
Entry is not recorded when a payment or receipt is merely due i.e., outstanding expenses,
accrued incomes are not treated.
This method is contradictory to the matching principle.
2. Accrual Basis of Accounting: Under this system of accounting, revenue and expenses
are recorded when they are recognized i.e., Income is recorded as Income when it is
accrued (when transaction takes place) irrespective of the fact whether cash is received or
not. Similarly, expenses are recorded when they are incurred or become due and not
when the cash is paid for them.
Under this system, expenses such as outstanding expenses, prepaid expenses, accrued
income and income received in advance are identified and taken into account.
Under the Companies’ amendments Act 2013, all companies are required to maintain
their accounts according to accrual basis of accounting.

Difference between accrual basis of accounting and cash basis of accounting

Basis Accrual Basis of Accounting Cash Basis of Accounting
Recording of Both cash and credit transactions
Only cash transactions are recorded.
transactions are recorded.
Profit or Loss is ascertained Correct profit/loss is not ascertained
Profit or Loss correctly due to complete record ofbecause it records only cash
transactions. transactions.
Distinction between This method does not make a
This method makes a distinction
Capital and Revenue distinction between capital and
between capital and revenue items.
items revenue items.
This basis is recognized under the This basis is not recognized under
Legal position
companies Act. the companies Act.

Advantages of Accrual Accounting

Accrual accounting has several advantages, most of which are related to accurate income and
expense reporting:

1. It provides an accurate picture of overall cash flow for the business. Many

business transactions occur over a period of several months and therefore several
accounting periods. Accrual accounting reflects that income and expenses generated in
one month can carry over into the next month or even longer.
 2. Investors prefer accrual accounting. A business that uses accrual accounting is often
looked at as more permanent and established than businesses that use cash-basis
accounting methods. 
3. It's the preferred method for GAAP. The Generally Accepted Accounting Principles
set forth by the Financial Accounting Standards Board prefers accrual accounting over
cash-basis accounting because the financial statements for a business that uses accrual
accounting are deemed more accurate since the transactions reflect when they actually
took place instead of when money is exchanged.

Disadvantages of Accrual Accounting 

There are some disadvantages to using the accrual accounting method, most of which revolve
around the staff needed to maintain the system:

1. Small companies might lack the staff needed to manage this method. Larger
companies typically have staff – even an entire department – dedicated to tracking and
reporting transactions. For example, a hospital might have an account receivables
department to keep track of patient billings, and an account payable department to track
hospital expenses.
2. Accrual basis accounting requires at least monthly reporting. In order to remain
accurate, accrual accounting needs frequent reports generated. These are usually the
monthly financial statements most business managers are familiar with, such as the
income statement and balance sheet. But accounts receivable and accounts payable
reports are often generated on a more frequent basis.
3. Taxes. Although an advantage to using accrual accounting is that you can report income
when the sale is incurred instead of waiting until you have cash on hand, this also means
a business pays taxes on money it hasn't received.

Advantages of cash basis of accounting

 Easy to Understand: Cash basis accounting tends to be simpler to understand than other

accounting methods. If you choose to implement the cash method for your small
business, it may not be necessary to seek the help of a professional accountant.
 Shows Cash Flow: The cash method most resembles a cash flow statement. It provides an
accurate picture of how much cash your business actually has on-hand.
 Single-Entry System: The cash method can be done with a simple single-entry system, so
a complex accounting program is not always necessary. This is, however, also one of its
drawbacks, which is outlined below.

Disadvantages of cash basis of accounting

 Single-Entry System: While the simplicity of the single-entry system needed for the cash
method is an advantage, it is also a disadvantage. The accrual method necessitates the use
of a double-entry system, which is based on accounting equations. This system provides
far greater control of transaction posting, and reduces the chance of errors.
 Short-Term Indicator: While it does indicate the cash flow of a business, it may offer a
misleading picture of longer-term profitability. The cash method doesn’t show income
that has been invoiced but not received. Furthermore, it doesn’t take future expenses into
account. It can also be misleading. For example, your books might show one month as
being extremely profitable. However, deeper insight may reveal that sales were actually
slow, but a number of customers paid their outstanding bills.
 Restrictions: According to the IRS, you cannot use the cash method if your business
maintains inventory, is a corporation, or has gross receipts in excess of five million
dollars per year. These are the general rules, but there are exceptions — so if you feel that
your business falls into one of these categories, you should consult a professional.