How to Choose Between Cash and Accrual Accounting for an Indian Company?
Before determining which method of accounting works best for your company, you must be able to know the significant differences between cash and accrual accounting:
A cash-based accounting system is the simplest method of accounting. Here, the revenues and expenses are accounted for after they are paid. Consequently, this method doesn’t recognize assets or payable.
This method is best suited to small businesses because it is simple to see when the transaction has been made. Moreover, there is no necessity to track receivables or payables. One needs to look into the bank balances to grasp the money available.
Think of it like this:
If an item worth Rs. 500 was sold in June, then the entry for the similar will be made in the books. But in the case where a similar good was sold in June and payment is due in July, then the entry for such will be made for July itself and not June.
Cash Accounting is best after you have plenty of transactions with the end consumer. This method can be suitable for smaller businesses like grocery or stationery.
Accrual Basis Accounting
Accrual accounting is a method of accounting where revenues and expenses are recorded when earned. It doesn’t account for the date when the cash was received or paid. When the delivery of the merchandise or service is complete, the revenue is recorded instead of anticipating payment.
The accrual method is an improvement over the cash method of accounting. It provides a practical, long-run view of business finances. A possible downside is that accrual accounting does not show any information about the money flow. Hence, because of this, many times, a business appears to be very profitable. While in reality, the business may even hold empty bank accounts. Accrual accounting without careful monitoring of money flow can have potentially devastating consequences.
The Effect on Cash Flow
The method of accounting was established to determine the income and expenses of an account. Let’s check out an example of how cash and accrual accounting affect the rock bottom line differently.
Imagine you perform the subsequent transactions during a month of business:
- Sent out an invoice for Rs 5,000 to a vendor for the service he offered this month
- Received a bill for Rs 1,000 from a client for work done this month
- Paid Rs 75 for the billing received last month
- Received Rs 1,000 from a client for a project invoiced last month
The Effect on Income
Using the cash-based accounting system method, the profit for this month would be Rs 925 (Rs 1,000 minus Rs 25)
- Using the accrual method, the gain for this month would be Rs 4,000 (Rs 5,000 minus Rs 1,000)
Which Method to Choose?
The Taxation Act in India allows non-corporate entities to keep up books of accounts on a cash-based accounting. Non-corporate entities in India may include a private, proprietary concern. A Hindu Undivided Family (HUF), a partnership firm, an LLP, a trust, etc., company entity viz public & private limited companies, LLPs required are to keep up the books of accounts only under an accrual-based accounting.
The Twelfth Finance Commission Report submitted to the government of India at Chapter 14- Institutional Changes and Reforms has recommended the introduction of the accrual-based system of accounting. The government has accepted this recommendation in theory, and GASAB has asked to draw a close road map and operational framework for its implementation.
A change in the method of accounting within the revenue enhancement has returned filed per year.
So first, identify your customers and on the nature of your business (corporate or non-corporate), select the right method of accounting.
Tax Implications on Non – Corporate Assesses
As everyone knows, any business owner or individual must pay taxes on their income. The strategy you decide on for accounting influences the tax amount that you pay. If the business owner has adopted cash-based accounting, then he’ll need to pay tax on the income received and not earned within the particular year. Similarly, in accrual accounting, taxes are paid on the earned income and not on received.
The difference between cash-based accounting and accrual accounting lies in the timing of recorded sales and purchases in your accounts. Cash-based accounting recognizes revenue and expenses only when money changes hands, while accrual accounting recognizes revenue at the time of earn, and is billed on expenses.
The 3E Accounting services professional team looks into your business requirements and specifies the method of accounting best suited for your business. We perform to our fullest to provide the best. You can contact us to get a consultancy regarding your business in India.