Company records the financial transactions based on the accounting principles or methods they follow. Such specific methods are to be disclosed in company’s annual report. There are two type of methods used in this accounting world to record financial transaction. Those are cash basis of accounting and accrual concept of accounting.
Cash basis of accounting
Under this method, expenses are recorded only when it’s paid to the party and the incomes are recorded after receiving the cash or amount into your bank account. If any transaction executed and its not paid or not received by the company then that is not recorded under this method of accounting
This method does not provide the correct profitability of your business for a particular period as the incomes are recorded as and when received not on the basis of accrual. For example: if a company sold a “32 inch television” to its customer on credit then the transaction will be recorded as and when the customer pays for it in cash or through bank. Similarly, if I have incurred rental expenses for the period but not yet paid to the landlord then it will not be recorded for the period.
The Profit and loss of a company derived on the basis of a principle called matching principle under which the income of a particular period will be matched with the expenses of that period for finding out the profitability of that particular period. Under this method of accounting we are not considering the matching principle of accounting as the incomes and expenses are not taken into account on due basis. As a result, the transactions are not exactly recorded for their respective period.
Accrual concept of Accounting
Under this method, revenues are recorded as and when its incurred rather taking it on the basis of money received (i.e. the transaction is recorded even if the customer has not paid and taken the goods on credit).
Expenses are handled in the same way by recording as and when it incurred for the period i.e. it’s recorded in the books of account even it’s not paid for.
Expenses and Revenues are matched under this method as transactions are recorded in book of accounts for a particular period as and when it incurred.
Cash basis of accounting is not used as it does not depict the true picture of a company. Suppose a company wants to show lower profitability then it can do so by asking its customer to pay after the due date of preparing the financial statements as a result income will be less as compare to the real income.