If you are a business owner, then you are required by law to maintain updated accounts for your business. There are several methods of keeping records from which you may choose. The method you choose depends entirely on your comfort level and understanding of the guidelines associated with the chosen accounting method.
In every country, respective government agencies mandate the maintenance of business accounts and require that said accounts accurately reflect the earnings and revenues of the business. In India, this falls under the responsibilities of the Income Tax Department. There are two main accounting methods that are utilized by business owners – the cash method, and the accrual method.
The cash method
Under this method, transactions are recorded as and when payment is received or made, i.e. realization of payments necessarily precedes the recording of the transaction. When payment is received for services rendered, it is recorded as income, and similarly only when funds are transferred for the acquisition of material for the business is it recorded as an expense. Hence if the business owner extends a line of credit to customers, or he/she acquires raw material on credit, the transactions will not be recorded until actual payment is realized.
However, this accounting method is in violation of the matching principle of accounting. The Matching Principle states that a business entity must record an expense in the same time period in which the related revenue is recorded, i.e. the expenses should ‘match’ the revenues in any chosen accounting period. Hence transactions are recorded as and when they occur and are independent of the time at which payment is realized.
The accrual method
Under this accounting method, a business owner records transactions as and when they take place, instead of waiting for payment to be realized. Hence recording a transaction in the business accounts is independent of the reception of cash for any service or payment of the same for an expense, and is done immediately after an expense is incurred or income is earned.
This method is favored by professionals due to its adherence to the matching principle, which is an important guideline for formal financial statements. It provides an accurate idea of the profitability of the firm in any chosen accounting period based on the business coming its way, which is measured by the number and volume of transactions on its business accounts.
Choosing an accounting method
The accounting method that you choose to settle on depends on various factors – the size of your business, availability of relevant professionals, a purpose of maintaining records…etc.
If you operate a small or medium sized business and maintain the business records yourself, then the cash method of accounting is more suited to your purpose as it is easier to understand and implement. Moreover, it depicts the exact condition of cash flows for your business and allows you to measure the liquidity of your assets at any point in time. Moreover, if the main purpose of maintaining records is adherence to local laws, then cash method offers the simplicity of manner for this purpose.
The accrual accounting method, on the other hand, is slightly complicated as compared to the cash method. However, if relevant professionals are available, and the business is large in size, then this method is preferable. It provides the owner with a succinct and clear picture of the financial strength of the business. The adherence to matching principle of accounting ensures that it is easier to understand the exact inflows and outflows of the business categorized by the accounting period.
Accrual method of accounting additionally lets one view at a glance the extent of the liabilities in terms of pending payments so that any misconceptions about the same are banished and the owner is not at risk of making erroneous judgments about the available and expected assets at any point in time.