In general, there are two accounting methods commonly used in business.
Cash basis accounting:
The first method is cash-based accounting, which is a relatively straightforward approach where transactions are recorded at the time when cash is received or paid. In this method, income is recognized when cash is received, and expenses are recognized when cash is paid out. The main distinction of cash-based accounting is the emphasis on the timing of transactions.
Cash-based accounting refers to a system where businesses recognize income and expenses only when cash is exchanged. In this method, invoices sent or bills received are not counted as income or expenses until they are settled. It is worth noting that cash-based accounting is not determined by the form of payment received and can include electronic payments.
The benefits of cash accounting include its simplicity and providing a clear picture of available funds. Additionally, businesses using cash-based accounting only pay taxes on the money they have received, which can help with cash flow. However, not all businesses are eligible to use cash-based accounting for tax purposes, so it is essential to consult with the relevant tax authority.
On the downside, cash accounting may not accurately reflect the profitability of a business as it does not consider unpaid bills. Moreover, it does not provide comprehensive financial information for making management decisions beyond the day-to-day view of finances.
The second method is accrual accounting, which involves recording transactions when revenue is earned and expenses are incurred, regardless of when the actual cash exchange takes place. Accrual accounting is widely endorsed by major accounting bodies and is often mandatory for preparing financial statements. It is important to note that under accrual accounting, the recording of revenue and expenses occurs independently of cash receipts and payments.
Accrual basis accounting, on the other hand, recognizes income when invoices are issued and treats bills as expenses even if payment is delayed. The benefits of accrual accounting include a more accurate representation of business performance and financial status, providing confidence for financial decision-making, and facilitating long-term finance arrangements.
However, accrual accounting requires more diligence as it involves tracking invoices in addition to monitoring the bank account. There is also a possibility of paying taxes on income before receiving payment from customers, but any uncollected taxes can be reclaimed on subsequent tax returns.
In some cases, businesses may opt for a hybrid accounting approach, combining elements of both cash and accrual accounting. This allows for a more comprehensive view of business performance while still keeping tabs on cash flow. Technology and accounting software can greatly assist in managing the complexities of accrual accounting, automating the process of recording invoices and expenses on an accrual basis. With a hybrid accounting system, businesses can switch between a cash basis and an accrual basis as needed, with smart software handling the transition smoothly.