There are 2 methods of accounting.
One is cash based and the other is accrual based.
i) Cash Basis Accounting System: In this system, transactions are recorded only subject to receipt or payment of cash. The transaction is entered only when cash is received or cash is paid. In practice, outstanding income or expenditure cannot be included in this method even if outstanding income or expenditure occurs alongside cash. As a result, financial statements may be misled by cash basis concepts. Income that is earned but not received is not accounted under the cash basis accounting method. which is contrary to the recognition of income. It is also need to mentioned that, the outstanding or future expenses are not matched against the income, which is not correct according to the matching principal. This is against the Generally Accepted Accounting Principle GAAP. In this method, the company has no assets other than cash.
ii) Accrual Basis Accounting System: This method is a full form of double entry system. In this method, all the transactions that have taken place during the accounting period, and all the future receivables and payables are brought the into account. It does not matter when this future income is received. Similarly, liability for expenditure is recognized as incurred.
In fact, the main theme of this method is that while preparing the revenue account and financial statement, the income and expenses received and due and paid and payable should be included in the account. As a result, the actual profit and financial status of the organization will be displayed appropriately. In this method all assets are represented separately.
Example: XYZ LLC is operating their business in the month of February. They have to pay $5,000 as office rent for the month of January, out of that XYZ LLC has due $5,000 as office rent for the month of December. Now they have to pay a total rent of $5,000 + $5,000 = $10,000.
Characteristics of Cash Basis Accounting system
1. Only cash transactions are accounted.
2. Payable and receivables are calculated for the corresponding accounting period. Payable, receivables of previous and subsequent accounting periods are not recognized.
3. Income and expenditure account is prepared based on cash income and cash expenditure.
4. It contains data gaps as not all transactions are accounted for.
5. A sole proprietorship type small businesses are suitable for. Also useful for organizations that only deal in cash.
6. Due to lack of complete data it is not possible to generate all types of reports and do comparative analysis.
7. Application of GAAP is not possible in this policy.
Characteristics of Accrual Basis Accounting system
1. In this accounting system cash and outstanding transactions are kept.
2. Payable receivables of the previous and subsequent accounting periods are considered besides calculating the payable receivables of the corresponding accounting period.
3. Income and Expenditure Account is prepared by reconciling cash and accrued income and expenditure.
4. Since all transactions are accounted for, there is no shortage of information.
5. It is the ideal method due to which it is applicable to all types of organizations, small, medium, large.
6. A variety of statements can be generated as a result of complete information being stored; Comparative analysis can also be done.
7. Generally Accepted Accounting Principle (GAAP) – Application is generally possible.