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Profit in the books and the movement in the bank balance do not agree, and the owner cannot see why.
Accrual accounting records income when earned and costs when incurred; cash basis records only when money moves. The gap between the two is made of debtors, creditors, advances and prepaid items.
Companies follow the accrual basis; proprietors choose a method and apply it consistently, with CA advice.
A period-end list of accruals and prepayments that explains, line by line, why profit differs from the bank movement.
Accrual accounting records income when it is earned and expenses when they are incurred, whatever the bank shows. Cash basis accounting records an entry only when money actually moves in or out. That is why, under accrual accounting, your profit and your bank balance almost never match, and why the difference has to be explained rather than ignored.
Which method does an Indian company have to follow, and what can a small proprietor choose?
An Indian company has no choice. The Companies Act, 2013 requires every company to keep its books of account on the accrual basis and according to the double-entry system. The accounting standards issued through ICAI and the Ind AS framework also assume accrual.
A sole proprietor or a small partnership has more room. For income tax, a business can follow either the cash or the mercantile (accrual) system, provided it is applied regularly and consistently. Many small traders start on cash basis because it mirrors the bank. As they grow, take a bank loan or come under tax audit, most move to accrual because lenders and auditors read accrual figures. The exact rules for your business should be confirmed with your CA, particularly as the Income-tax Act, 2025 has renumbered the provisions from 1 April 2026.
A worked example: two March transactions, two answers
Suppose a consultant raises a ₹50,000 invoice on 28 March, and the client pays it on 10 April. The same month, the office uses ₹12,000 of electricity, and the bill is paid on 5 April.
| Item | Accrual basis (FY 2025-26, March) | Cash basis (FY 2025-26, March) | Cash basis (FY 2026-27, April) |
|---|---|---|---|
| Consulting invoice | Income ₹50,000 | Nothing | Income ₹50,000 |
| Electricity for March | Expense ₹12,000 | Nothing | Expense ₹12,000 |
| Profit effect | ₹38,000 | ₹0 | ₹38,000 |
| Bank movement in March | ₹0 | ₹0 | Net +₹38,000 |
Under accrual accounting, March shows a profit of ₹38,000 (₹50,000 less ₹12,000) even though the bank did not move. The books carry a ₹50,000 debtor and a ₹12,000 creditor. Under cash basis, March shows nothing, and the whole ₹38,000 lands in the next financial year. Same business, same work, a different year of profit.
How five common events are recorded under each method
| Event | Accrual basis | Cash basis |
|---|---|---|
| Credit sale of ₹1,18,000 | Income when the invoice is raised; customer becomes a debtor | Income only when the customer pays |
| Advance of ₹20,000 received | A liability (advance from customer) until the work is done | Income on the day it is received |
| Rent of ₹90,000 paid for 3 months in advance | Only the current month’s ₹30,000 is an expense; ₹60,000 is prepaid | Full ₹90,000 is an expense on payment |
| March salary of ₹2,40,000 paid on 7 April | Expense in March; salary payable at month end | Expense in April |
| Bank interest credited on 31 March | Income in March, matched with the bank | Income in March, matched with the bank |
Bank interest is the only line where both methods agree, because the cash movement and the earning happen on the same day.
Why do profit and bank balance differ under accrual accounting, and how does reconciliation explain the gap?
Under accrual accounting, profit and cash part company whenever earning and paying fall on different dates. The gap is not random. It is made up of four kinds of balance:
- Debtors – income earned, cash not yet received.
- Creditors and payables – expenses incurred, cash not yet paid.
- Advances received – cash received, income not yet earned.
- Prepaid expenses – cash paid, expense not yet incurred.
Reconciliation is the process of proving each of these balances. You tie debtors to customer statements, creditors to vendor statements and the bank account to the bank statement. Once each balance is proved, the difference between profit and the bank movement is fully explained. When it cannot be explained, something has been missed, duplicated or posted to the wrong period.
A practical habit for owners: at each month end, ask your accountant for a one-page bridge from profit to the change in bank balance. If the bridge does not close, the books are not ready.
Period-end adjustments bring the books to accrual
Many small businesses record day-to-day transactions as cash moves and then pass adjustment entries at the month or year end. These entries add unpaid bills, remove advance receipts from income and spread prepaid costs. Two decisions sit behind these adjustments: when a sale counts as revenue, and whether a cost is an expense or an asset.
What to read next
- Next in this series: When should I book this revenue in my books?
- Is this expense capex or revenue in my books?
- Day book, cash book and ledger: which book records what?
- How finance teams prove every balance: account reconciliation software in India