Basis and Approaches Used for Accounting
From the point of view the timing of recognition of revenue and costs, there can be two broad approaches to accounting.
- Cash basis
- Accrual basis.
Under the cash basis, entries in the book of accounts are made when cash is received or paid and not when the receipt or payment becomes due. Let us say, for example, if office rent for the month of December 2005, is paid in January 2006, it would be recorded in the book of account only in January 2006. Similarly sale of goods on credit in the month of January 2006 would not be recorded in January but say in April, when the payment for the same is received. Lets Say another example a stock is sold on credit to customer . Customer Didn't pay you now then that sales entry will not be noted as Cash is not yet Received. Lets say it has given payment after 2 days then sales entry will be made on date when you received cash . Thus this system is incompatible with the matching principle, which states that the revenue of a period is matched with the cost of the same period. Though simple, this method is inappropriate for most organisations as profit is calculated as a difference between the receipts and disbursement of money for the given period rather than on happening of the transactions. Small Business owner have a mythology that business is only done after you receives cash for it . Small businesses mainly works on this mythology
Under the accrual basis, however, revenues and costs are recognized in the period in which they occur rather when they are paid. A distinction is made between the receipt of cash and the right to receive cash and payment of cash and legal obligation to pay cash. Thus, under this system, the monitory effect of a transaction is taken into account in the period in which they are earned rather than in the period in which cash is actually received or paid by the enterprise. This is a more appropriate basis for the calculation of profits as expenses are matched against revenue earned in relation thereto. For example, raw material consumed are matched against the cost of goods sold.In Other Example Let say a product is sold on credit to customer then also its Sales Entry is made in books of accounts .