Methods of Accounting

The rules that a business follows to keep track of and record its financial actions are called its accounting procedures. Its main job is to show how much money a company makes and how much it spends. Businesses use a number of different accounting ways to keep track of their money. Most people have these:

  1. Cash Basis Accounting: This method of accounting makes sure that income and expenses are recorded as soon as cash comes in or goes out, no matter when the transaction actually took place. This measure is simple, and it may give us a basic idea of how big businesses will do financially in the long run.
Limitations of Cash Basis Accounting

The cash basis of accounting has a number of advantages, particularly for individuals or   small enterprises who engage in uncomplicated financial transactions. Among the most important benefits are the following:

  • Simplicity: Easy to understand and requires minimal record-keeping.
  • Ease of Implementation: Quick to set up and maintain.
  • Immediate Cash Flow Recognition: Offers a transparent understanding of the flow of funds in real time.
  • Reduced Administrative Burden: Fewer hours spent on complex accounting responsibilities.
  • Tax Advantages: Tax liabilities can be better managed, and cash flow can be improved.
  • Suitability for Certain Industries: Well-suited for businesses with simple cash flows.
  • Cost Savings: Reduces accounting costs and overhead expenses.
Demerits of cash basis of accounting

The limitations of the Cash basis of accounting are stipulated below: –

  • Limited Insight: Oversimplifies financial health by excluding accrued transactions.
  • Profit Distortion: May misrepresent profitability due to cash-based timing.
  • Cash Flow Complexity: Difficulties in managing cash flow without considering receivables or payables.
  • Tax Disadvantage: Potential for higher taxes as income is recognized upon receipt.
  • Financing Challenges: Reduced access to loans due to simplified financial reporting.
  • Regulatory Hurdles: Difficulty complying with regulations requiring accrual basis reporting.
  • Unsuitable for Complexity: Inadequate for businesses with intricate financial operations.
  1. Accrual Basis Accounting: This method doesn’t care when money comes in or goes out; it just records income and expenditures when they happen. A more involved kind of accounting known as the accrual method necessitates recording incoming revenue and expenditures regardless of whether payment has been received or not. Put simply, expenses are recorded upon receipt of the invoice, but income for a long-term contract is recorded upon finalization of the agreement.
Benefits of Accrual Basis Accounting

Accrual basis accounting, a widely adopted method in business finance, offers distinct advantages:

  • Accuracy: Provides a more accurate view of financial position and performance.
  • Informed Decision Making: Enables better forecasting and planning.
  • Performance Evaluation: Allows for more accurate assessment of operational efficiency.
  • Credibility: Enhances trust and transparency in financial reporting.
  • Compliance: Aligns with accounting standards, ensuring reliability.
  • Tax Planning: Facilitates effective tax management strategies.
  • Audit and Due Diligence: Simplifies auditing processes and due diligence evaluations.
Limitations Accrual Basis Accounting

Below are the limitations of Accrual Basis of   Accounting: –

  • Complexity: Requires understanding of accounting principles.
  • Cash Flow Distortion: May not reflect actual cash flow accurately.
  • Delayed Recognition: Recognition of income or expenses may be delayed.
  • Subjectivity: Involves estimates and judgments.
  • Manipulation Risk: Potential for financial statement manipulation.
  • Inadequate for Small Businesses: Burdensome for simple operations.
  • Compliance Challenges: Adherence to accounting standards may be challenging.
  • Deferred Tax Impact: Can result in deferred tax liabilities/assets.

In summary, cash basis accounting is simple but may distort financial health, while accrual basis accounting offers accuracy but requires understanding and may delay recognition. The choice depends on a business’s size and goals.