Accrual or Cash Basis: Why Your Profit Depends on the Method
- One month, both ways
- Where each difference comes from
- The entries behind the accrual column
- Why accrual is the standard
- What cash-basis thinking is still good for
- Three accrual mistakes that distort a small business’s profit
- Where this fits
Cash-basis accounting records income when money arrives and expenses when money leaves. Accrual accounting records income when it is earned and expenses when they are incurred, regardless of when cash moves. The same business, in the same month, can show a loss under one method and a profit under the other, and both are arithmetically correct.
Accrual is the method that tells you whether the business is working. Cash is the method that tells you whether you can pay the bills. You need both answers, which is why a proper set of accounts is kept on accruals and read alongside a cash flow statement.
One month, both ways
A small consultancy has four transactions relating to March:
- On 25 March it finishes a project and invoices the client ₹2,00,000. The client pays on 10 April.
- March office rent of ₹40,000 is paid on 5 April.
- On 1 March it pays ₹60,000 for a twelve-month software subscription.
- March salaries of ₹90,000 are paid on 31 March.
| Item | Cash basis, March | Accrual basis, March |
|---|---|---|
| Fee income | 0 | 2,00,000 |
| Rent | 0 | (40,000) |
| Software | (60,000) | (5,000) |
| Salaries | (90,000) | (90,000) |
| Result for March | (1,50,000) | 65,000 |
On a cash basis March looks like a disaster. On accruals it was a profitable month in which the cash simply had not arrived yet. April, on a cash basis, will look spectacular for the opposite reason.
Where each difference comes from
The fee. The work was done and billed in March. Under accruals it is March revenue, and the unpaid amount sits on the balance sheet as a trade receivable until April.
The rent. The office was used in March, so March bears the cost even though the payment was made in April. It is an accrued expense, a liability at 31 March.
The software. Paying a year upfront does not make March twelve times as expensive as April. Accruals spread it: ₹5,000 a month, with the remaining ₹55,000 sitting as a prepaid expense, an asset, at the end of March.
The salaries. Earned and paid in March. Both methods agree. When cash and the underlying event fall in the same period, the methods give the same answer, which is why the gap only shows up around month-ends and on larger, lumpy items.
The entries behind the accrual column
| Date | Debit | Credit | ₹ |
|---|---|---|---|
| 1 Mar | Prepaid expenses | Bank | 60,000 |
| 25 Mar | Trade receivables | Fee income | 2,00,000 |
| 31 Mar | Salaries | Bank | 90,000 |
| 31 Mar | Software expense | Prepaid expenses | 5,000 |
| 31 Mar | Rent | Rent payable | 40,000 |
| 5 Apr | Rent payable | Bank | 40,000 |
| 10 Apr | Bank | Trade receivables | 2,00,000 |
GST on the invoice and on the rent is left out to keep the example readable. In real books it would be recorded on the same dates, as output tax payable and input tax credit.
Notice what the April entries do: they only move money between the bank and the balance sheet accounts created in March. They touch no income or expense account, so April’s profit is not distorted by March’s business.
Why accrual is the standard
Companies do not get a choice. Section 128(1) of the Companies Act, 2013 requires books of account to be kept on an accrual basis and according to the double-entry system, and the accounting standards are built on the same assumption.
The deeper reason is comparability. Under cash accounting, a month’s result depends on when a client happens to pay and when you happen to settle a bill, so month-on-month comparisons tell you about payment timing, not performance. Under accruals, March’s revenue sits with March’s costs, and a falling margin actually means a falling margin.
Accruals also stop a business fooling itself. A cash-basis owner who delays paying suppliers for three months sees three profitable months. The accrual books show the liabilities piling up.
What cash-basis thinking is still good for
Very small businesses often run their day-to-day view on cash because it is simple and it matches the bank statement. That is fine for knowing whether you can pay salaries next week. It is not fine for pricing, for deciding whether a client is profitable, or for showing a bank.
The practical approach for a growing business is to keep the books on accruals, which your accountant needs anyway, and watch cash separately with a short 13-week cash flow forecast. That gives you both answers without mixing them up.
Tax rules on which method a particular kind of taxpayer may use are a separate question from accounting, and depend on the entity and the law applicable to the year. This article does not cover them.
Three accrual mistakes that distort a small business’s profit
- Booking annual payments as a one-month expense. Insurance, software, annual maintenance contracts. The month of payment looks terrible and the other eleven look better than they are.
- Forgetting unbilled expenses at year-end. The March electricity bill that arrives in April, the audit fee for the year just closed. Leaving them out overstates the year’s profit.
- Recognising advance receipts as income. A client paying six months upfront has not given you six months of revenue. Until the work is done, that money is a liability.
Where this fits
- The side-by-side comparison: profit vs cash flow
- When the two drift apart for real: profitable but no cash in the bank
- The month-end routine that captures accruals: month-end close checklist
- The mechanics of debits and credits: debits and credits explained