How to choose the correct accounting method
Remember, a creditor (banks, investors) will be more interested in the liquidity of your business and shareholders will be concerned about market value of shares. You as the owner/manager of the business will always be more interested in the profitability and credibility of your business. So it’s important for you to choose the correct accounting method.
Cash accounting methods are based on cash flows. Transactions are recorded whenever there is a cash inflow or outflow. For example, income is when you receive cash, credit card or cheques and expenses are put down when you have to pay out by above mentioned means.
Accrual accounting systems are based on the timeline of transactions. For example, if your business earns income in February but isn’t paid till April, accrual accounting methods will still record income in February.
In the Indian Small Business context, it’s better to adopt accrual methods because often products/services are sold earlier and payment is realized later. On the other hand, cash accounting will give you a realistic picture of your cash flow at all times.
The cash method will actually postpone your tax liability in your actual year of income whereas the accrual method requires full taxes to be paid in the year the income is realized.
The accrual method is in compliance with the GAAP (Generally Accepted Accounting Principles).
GAAP (Generally Accepted Accounting Principles) are the standard and accepted norms practiced in the domestic market. These standards are followed by Financial Accounts Standards Board (FASB).
The sincerity principle states that the accounts should reflect the company’s true financial picture without resorting to fraudulent means.
The consistency principle states that once a business has decided upon a particular accounting method, the same should be followed for all items.
The accounting style should remain constant throughout the entire financial year preferable through 3 financial cycles so that justifiable yearly comparisons can be made.
The non-compensation principle states that full details of financial information should be provided without compensating revenues with expenses, debts with assets or similar processes.
The prudency principle states that revenue should be entered in the accounting books only when it is realized (certain) and expense provisions should be made only if they are recurring and certain.
Assets should always be depicted by their historical value and not at their current market value.
Principle of periodicity states that each accounting entry should be put down in its proper period. For example if a customer pays your business a lease value for the entire year, the revenue amount should be split to cover the entire time span.