There are basically two systems of accounting:
Cash System of Accounting:
It is a system in which accounting entries are made only when cash is received or paid. No entry is made when a payment or receipt is merely due. Certain professional people and small business houses record their income on cash basis, but while recording expenses they take into account the outstanding expenses also. In such a case, the financial statement prepared by them for determination of their income is termed as “Receipts and Expenditure Account”
Accrual System of Accounting:
It is a system in which accounting entries are made on the basis of amounts having become due for payment or receipt. This system recognizes the fact that if a transaction or an event has occurred; its consequences cannot be avoided and therefore should be brought into record in order to present a meaningful picture of profit earned or loss suffered during a period and also of the financial position of the firm concerned at the end of a period.
Difference between cash and accrual system:
The difference will be clear with the help of the following example:
A firm closes its books on December 31st each year. A sum of Rs.5,000 has become due for payment on account of rent for the year 2000. The amount has, however been paid in January 2001.
In this case, if the firm is following cash system of accounting, no entry will be made for the rent having become due in the books of accounts of the firm in 2000. The entry will be made only in January 2001 when the rent is actually paid. However, if the firm is following accrual system of accounting, two entries will be made:
On December 31st 2000, rent account will be debited while the rent payable account will be credited by the amount of outstanding rent.
In January 2001 rent payable account will be debited while the cash account will be credited with the amount of the rent actually paid.
The ‘Accrual system’ is considered to be better since it takes account the effects of all transactions already entered into. This system is followed by most of the industrial and commercial firms.