Cash and Accrual System of Accounting

There are two principle methods of Accounting. One is the cash system of accounting and second, the accrual system of accounting.

Cash System of Accounting        

In this system, accounting entries are made in the books only when there is cash flow, either inflow i.e., receipt of cash or outflow or payment in cash. In this system income is accounted for when cash is actually received and expenses are accounted for when cash is actually paid. No record for the incomes and expenses that are due or outstanding are maintained. The end result of this method is called the net operating cash flow i.e., cash receipts less the cash outflows. This system of accounting is easy to understand and is based on the factual flow of cash. The evidence necessary to justify the entries is readily and easily available. However this system has its own disadvantages. The present cash flows of a concern cannot be used to predict the future ability of the concern to generate cash flows (cash generating ability). The pure cash basis is not evidenced by logic as it does not facilitate the fundamental requisite of matching the revenues with the costs incurred for earning for those revenues. GAAP does not permit application of cash system of accounting.

Certain professionals such as lawyers, advocates, cost accountants, etc. maintain their books on Cash System of Accounting. However, they also keep a record for the outstanding expenses. The Financial Statements prepared for determination of income are called Receipts and Payments accounts.   

Accrual System of Accounting

The term accrual means the fiscal recording of items pertaining to a current period which would not have appeared in the accounts until a future period in the normal course of payment or receipt in respect of the items.

In this system, transactions are accounted for on their happening regardless of whether cash has been received or not. This system recognizes the fact that if a transaction or event has occurred, its consequences cannot be avoided and must be brought to books regardless of whether cash flow has resulted or not. Accrual accounting is also known as mercantile accounting. Under the accrual system, the actual receipts or payments is not taken as the base. The revenues are recognized if they belong to the relevant accounting period irrespective of whether cash or cash equivalent is received or not. Expenses are recognized if they are relatable to the revenues earned and accounted in the said period, irrespective of whether they are paid or not. Expenses shall also include an accepted allocation of past costs (e.g., depreciation) and costs which are in the nature of permanent losses (e.g., fire/theft) as such costs arise directly in the course of conducting the business with the motive of making profits. The accrual accounting is used by majority of  profit-oriented companies and non-profit companies. In this system of accounting the resource accomplishments or inflows are called revenue and the measure of resource sacrifice is called expenses. The net result is called the net income.

    For example, an enterprise (A. Ltd.)  purchases a new laser printer on credit in May and makes payment of  Rs.12,000  in July, two months later. Using cash system of accounting A. Ltd.  would record a Rs.12,000 as expense  for the month of July, the month when the money is actually paid. But under the accrual method, the Rs.12,000 payment would be recorded in May, when A. Ltd.  takes the delivery of the laser printer and become obligated to pay for it. Similarly, where B. Ltd. undertakes a computer installation business and completes the  job on November 30, 2007, and doesn't get paid until January 10, 2008; B. Ltd.  records  the payment in January 2008 under the  cash system of accounting.  Under the accrual method the income would be recorded in the books of B. Ltd. in November 2007.

    Unless or otherwise specified the system adopted is always the Accrual Basis.