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What is Accounting?
Accounting is a subject that deals in the day or day recording of business transactions. The process of accounting starts with the recording of journal entries. Journal entries are entries that are used to record the daily business transactions. Journal Entries are recorded based on three golden rules of accounting. After recording the journal entries, ledger accounts are prepared for every head under accounting. Ledgers are prepared to know the as on balances left under a particular head. The next process is making a Trial Balance. Trial Balance evaluates the arithmetical accuracy of the books of accounts. After preparing the Trial Balance, a Profit and Loss Account and Balance Sheet is prepared. The profit and loss account is prepared to find out the net profit and loss earned by a company in a given financial year. Balance Sheet is a statement of Assets and Liabilities. Companies prepare separate accounts for the separate financial year. Generally, a financial year starts in April and ends in March.
There are two approaches to making accounts for a company. One is the Cash Accounting Approach and the second is the Accrual Accounting Approach.
Under the cash accounting approach, the transactions are recorded in the books of accounts only when the actual payment is made or payment is received. For example, if a company sells its product to a particular person on credit. However, the company does not receive any payment form that customer in that particular year. Under the cash accounting system of accounting, the sale is however recorded in the year in which the company receives the payment against the sales made and not in the year in which the sale is made.
Under the accrual accounting approach, the transactions are recorded in the books of accounts in the year to which the transaction pertains. It does not matter whether the company has received or paid any cash or not. For e.g. If a company makes a sale of a product to its customer on credit. However, the company does not receive any payment against the sale made in that particular year. In the accrual concept of accounting, the company will record the transaction in the same year in which the sale is made, no matter payment is received against the sale or not.
1. Timing of recognition
The timing of recognition of transactions is the main difference between the accrual system of accounting and the cash system of accounting. The transactions in the accrual system are recorded in the year to which the transaction pertains. The transaction in the cash system of accounting is recorded in the year in which actual payment and receipt of cash take place.
The accrual basis of accounting is accepted widely as per the Companies Act, 2013. However, the cash system of accounting is not accepted as a standard means of accounting as per the Companies Act, 2013.
3. Profit level.
By applying the cash system of accounting in preparing the Income Statement, the profit level gets reduced or increased. The main reason behind it is that it may so happen that a company did not receive a particular payment or pay any bill in the same accounting year. However, by following the accrual system of accounting, the profit of the company is calculated considering all the transactions.
4. Degree of Accuracy
The degree of accuracy increases by following the accrual system of accounting. This is due to considering all the transactions. However, the accuracy level decreases by following the cash basis of accounting.
5. Simplicity level
Preparing accounts under a cash basis is fairly simple as the transactions are to be recorded only when money is received or paid. However, it is a bit complex to follow the accrual concept. As the transactions are recorded in the year to which it pertains. An adjustment entry is to be passed in the year in which the payment is to be received.
Almost all the companies in the world follow the accrual system of accounting. This is the standard form of accounting. It is also very important to maintain consistency in the method of accounting you follow every year. This will enable you to compare the financial transactions each year.
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