The business enterprises use accounting to calculate the profit from the business activities at the end of given period. There are two basis of calculating the profit, namely, the cash basis and accrual basis.
(i) Cash basis of accounting : In this basis of accounting, the income is calculated as the excess of actual cash receipts in respect of sale of goods, services, properties, etc., over actual cash payments regarding purchase of goods, expenses on rent, electricity, salaries, etc. Credit transactions are not considered at all including adjustments for outstanding expenses and accrued income items. This method is useful for professional people like doctors, engineers, advocates, chartered accountants, brokers and small traders. It is simple to adopt because there are no adjustment entries. But this basis does not disclose the true profits because it does not consider the income and expense items which relate to the accounting period but not paid in cash. Moreover, this method is not applicable where the number of transactions is very large and expenditure on fixed assets is high. The income or profit is calculated with the help of receipts and payments account.
(ii) Accrual basis of accounting : Under this method the items of income (revenue) are recognized when they are earned and not when the money is actually received later on. Similarly expense items are recognized when incurred and not when actual payments are made for them. It means revenue and expenses arc taken into consideration for the purpose of income determination on the basis of the accounting period to which they relate. The accrual basis makes a distinction between actual receipts of cash and the right to receive cash for revenues and the actual payments of cash and legal obligations to pay expenses. It means that income accrued in the current year becomes the income of current year whether the cash for that item of income is received in the current year or it was received in the previous year or it will be received in the next year. The same is true of expense items. Expense item is recorded if it becomes payable in the current year whether it is paid in the current year or it was paid in the previous year or it will be paid in the next year. The advantages of this system are: (a) it is based on all business transaction of the year and, therefore, discloses thc’current profit or loss; (b) the method is used in all types of business units; (c) it is more scientific and rational application; (d) it is most suitable for the application of matching principle. The disadvantages are: (a) it is not simple one and requires the use of estimates and personal judgement; (b) it fails to disclose the actual cash flows. (iii) Mixed or Hybrid basis of accounting: Under this method revenues (items of income) are recognized on cash basis while the expenses are recorded on accrual basis. The purpose is to remain cautious, safe and hundred per cent certain for revenues items and make adequate provisions for expenses.