Reviewed by Oct 05, 2020| Updated on
The method of reporting revenues and expenses adopted by a company is known as an accounting method. There are two major accounting methods used across the world—accrual accounting and cash accounting. The former method reports revenue and expenses when they are received and paid, whereas the latter method reports the revenue and expenses as soon as the transaction occurs.
Cash accounting is the simplest accounting method and is widely used by small businesses. Also, the transaction is only recorded when the cash is spent or received, that is a sale is recorded when the payment is received, and an expense is recorded when a bill is paid. This is the method used by commoners in managing personal finances and works for businesses up to a certain size.
Accrual (mercantile) accounting works based on a matching principle, i.e. the timing of revenue and expense recognition much match. The process of matching revenue with expense draws a better picture of a company's financial condition. In this method, the purchase order is recorded as revenue even though the payment is not received. Similarly, expenses are recorded even though the payment is not yet made.
The third accounting method is the hybrid method, which is a blend of cash and accrual methods along with the essence of many other special accounting methods. This method can be used in internal accounting and for tax purposes.
The Income Tax Act, 1961, has instructed how each of the five heads of income must be recorded. The act says that the salaries, income from house property, and capital gains must be recorded using the accrual method.
For the heads—profits and gains of business or profession and income from other sources, such as business profits, investment income, and professional income—you can choose the cash accounting or accrual accounting method as stated in section 145 of the Income Tax Act. Prior to the enforcement of section 145, the hybrid method was widely used for this.