Bookkeeping Basics: Cash vs Accrual

TL;DR

Cash accounting records transactions when cash moves.

This is the foundation guide — the conceptual primer on cash vs accrual bookkeeping for an Indian small business. The companion piece, Cash basis bookkeeping fails at ₹1 crore revenue, covers the operational thresholds and the migration path. This post explains what each method means, who should use which, and the practical implications for GST and income tax.

What Each Method Means

Cash accounting

Under cash accounting, you record income when the cash is received and expenses when the cash is paid. The transaction date is the bank transaction date (or the date of cash receipt / payment in a petty cash book).

Cash accounting is simple. The P&L tracks the bank account. There is no accounts receivable, no accounts payable, no inventory accounting. For a sole proprietorship with all-cash receipts, all-cash payments, and no inventory, cash accounting is functionally equivalent to accrual — every transaction is both the economic event and the cash event.

Cash accounting distorts the P&L when:

• You bill customers on credit (you raised the invoice but the cash is in next month).
• You pay suppliers on credit (you received the goods but the cash goes out later).
• You carry inventory (you paid for the goods but the cost is recognised only on sale).
• You prepay expenses (you paid for the year but the expense is spread across the year).

Accrual accounting

Under accrual accounting, you record income when it is earned (the invoice is raised, the service is performed, the goods are delivered) and expenses when they are incurred (the goods are received, the service is consumed). The cash flow is tracked separately.

Accrual accounting aligns the P&L with the economic activity of the business, not the cash flow. For a business with credit terms, inventory, or prepaid expenses, accrual is the only method that produces a meaningful P&L.

Accrual accounting requires:

• Accounts receivable — track customer invoices and outstanding balances.
• Accounts payable — track supplier invoices and outstanding balances.
• Inventory — track raw materials, work-in-progress, finished goods.
• Prepaid expenses — track expenses paid in advance.
• Accrued expenses — track expenses incurred but not yet paid.
• Deferred revenue — track income received in advance.
• Fixed asset register — track capital expenditure and depreciation.

For most small businesses, this is implemented in Tally Prime, Zoho Books, or QuickBooks. The software handles the double-entry accounting and produces the P&L and Balance Sheet.

Why GST Prefers Accrual

GST returns are filed on an invoice basis (accrual in spirit), not on a cash basis:

• GSTR-1 — outward supplies are declared for the month in which the invoice is issued, not when the cash is received.
• GSTR-3B — the tax is paid for the month in which the invoice is issued (with payment actually happening in the next month or by the 20th of the following month).
• GSTR-2B — the ITC is auto-generated based on the supplier’s GSTR-1, which is on an invoice basis.

If your books are on cash basis and your GSTR-1 is on accrual basis, you have a reconciliation problem every month. The books say ₹10 lakh in sales for the month (because ₹10 lakh was collected); the GSTR-1 says ₹12 lakh in sales (because ₹12 lakh was invoiced, including the credit sales). The variance grows over the year.

For a business with regular GSTR-1 / GSTR-3B filings, the practical answer is to maintain accrual books — even if you have an underlying cash-flow reason to track cash basis separately for internal decisions.

Why Income Tax Prefers Accrual

For companies and for assessees above the audit threshold (Section 44AB):

• Audit requirement — turnover > ₹1 crore (or > ₹10 crore if 75% of transactions are digital) requires a tax audit under Section 44AB.
• Audit standard — the audit is on accrual basis. The auditor reconciles cash basis to accrual basis for the purpose of the audit report.
• Income recognition — income is recognised on accrual basis (Section 145 of the Income-tax Act).

For a sole proprietorship or partnership below the audit threshold, cash basis is allowed for income tax — but with significant limitations:

• Mixed income — if you have both business income and non-business income (interest, dividend, salary), the business income is on accrual, the non-business is on cash. Mixing methods is allowed but messy.
• Year-end adjustments — if you have inventory, the year-end inventory is deducted from purchases under the “stock-in-trade” rule. This implicitly shifts you to accrual.
• Section 145 — the method of accounting must be consistently applied and clearly reflect income. Cash basis is accepted only when it consistently and clearly reflects income.

The Practical Recommendation

When to use cash basis

Cash basis is appropriate for:

• A sole proprietorship with no inventory, all-cash receipts, all-cash payments, turnover below ₹25 lakh, and no GST registration.
• A freelancer or consultant with no employees, no inventory, and no credit terms.
• A small rental property owner with one or two properties and direct collection from tenants.

For these profiles, accrual bookkeeping is overhead. The bank statement is the P&L. The GST registration is voluntary and may not apply.

When to use accrual basis

Accrual basis is required for:

• Any business with GST registration — the GSTR-1 / GSTR-3B mismatch is unmanageable on cash basis.
• Any business with turnover above ₹1 crore — the audit under Section 44AB requires accrual.
• Any business with inventory, credit terms, or prepaid expenses — cash basis distorts the P&L beyond usefulness.
• Any business planning to raise funding, sell, or IPO — the financials must be on accrual.
• Any company (Pvt Ltd, LLP, OPC) — the Companies Act requires accrual accounting for the financial statements.

The hybrid approach (rare)

A small number of businesses maintain dual books: cash basis for internal cash-flow decisions, accrual basis for GST and tax filing. The reconciliation between the two is done monthly. This is practical only for a business with a full-time accountant or a CA-led bookkeeping team.

For most small businesses, the right answer is accrual basis throughout — and a separate cash-flow report for management decisions.

The Migration from Cash to Accrual

For a business currently on cash basis and migrating to accrual, the migration is a 30-day project:

1. Pick a cut-off date. The start of the next financial year is cleanest. The books are migrated on Day 1 of FY.
2. Set up the chart of accounts. Add trade receivables, trade payables, inventory, prepaid expenses, accrued expenses, deferred revenue, advances to / from customers. Tally Prime and Zoho Books have default charts that cover these.
3. Open the balances. The trade receivables, trade payables, and inventory as of the cut-off date are the opening balances. The values come from a one-time count and reconciliation.
4. Run parallel books for one quarter. For the first three months, maintain both sets. Reconcile monthly. The variance between the two methods should be small and explainable.
5. Switch. From Month 4, use the accrual books as the primary.

The cost of the migration is one-time professional fees for a CA / accountant. For a small business, ₹25,000–₹60,000 covers the setup and the first three months of reconciliation. The ongoing cost is the same or lower than cash basis — the GST reconciliation is faster (the books match the returns), and the bank reconciliation is faster (the books match the bank).

Common Pitfalls in Accrual Adoption

Pitfall 1 — Wrong opening balance for inventory

The opening inventory is set to the previous year’s closing inventory. If the previous year’s closing inventory was on cash basis (i.e., purchases recorded as expenses), the accrual opening balance is artificially low. The first year of accrual books shows artificially high COGS.

Pitfall 2 — Mistiming the revenue cut-off

Sales raised in the last week of the FY are recorded as next year’s sales because the cash arrives in April. The cut-off must be on the invoice date, not the cash receipt date. The cut-off exercise at year-end is critical.

Pitfall 3 — Forgetting the prepaid adjustments

Annual insurance premiums, advance rent, annual subscriptions — paid in cash in one month, expensed over 12 months. The prepaid schedule is the adjustment. Without it, the P&L shows an artificial expense in the month of payment.

Pitfall 4 — Mixing depreciation methods

Capital expenditure is depreciated over the useful life of the asset. Different depreciation methods (WDV vs SLM) produce different P&L. The Companies Act prescribes WDV for most asset classes. The Income-tax Act prescribes WDV with block-wise rates. Maintain consistency.

The Single Most Important Advice

If you have a GST registration or if your turnover exceeds ₹1 crore, migrate to accrual bookkeeping now. The cash basis distorts the P&L beyond usefulness for management decisions, and the GST reconciliation on cash basis is a recurring monthly headache. The migration is a one-time cost; the ongoing benefit is meaningful.

For the operational thresholds and the migration path, see our Cash basis bookkeeping fails at ₹1 crore revenue guide. For the broader software choice (Tally vs Zoho Books vs QuickBooks), see our software comparison guide.

Sources

• Income Tax Act — Section 145 (method of accounting), Section 44AB (audit)
• Institute of Chartered Accountants of India (ICAI)