Full Accrual, Modified Accrual and Cash Budget - Assignment Example

Questions: Alternative A Name Institution Full Accrual, Modified Accrual and Cash Budget Introduction Cash budgeting is the simplest accounting method as it resembles having a chequebook (Weygandt et al., 2010). Cash is usually recorded when it is put into the bank while expenses are on the other hand recorded when a cheque is drawn to pay a bill without reflection of uncollected assessments or unpaid bills . According to Black (2008), cash accounting considers the firm’s cash flows without upholding the matching principle. Expenses and revenues are recognized when cash changes hands and not when it is actually earned or during the period of benefit. When there are significant cash on hand amounts, it is possible to purchase goods whose future payments will be pending or offer credit to its customers without being concerned about excess. Within the cash method, it therefore becomes possible to defer taxable incomes through the delay of billing or acceleration of expenses through swift making of payments. Cash accounting is mostly used where firms get advance payments and have to pay up for their inventories during the time of their delivery. In such circumstances, cash accounting works best and offers adequate details that will enable the accurate keeping of records. For example, a tanning salon usually offers its services to members of the public who pay in advance. The expenses it incurs include the purchase of tanning oil which it buys in cash and also various utilities which are also due when bills are received. Cash accounting will work best for the salon because all its financial outlays and incomes already take the form of cash payments (Needles et al., 2011). According to Clare (1994), full Accrual Accounting differs from cash accounting. This is because rather than tracking cash flow, it tracks transactions. All incomes are recorded at the time when they are earned while the expenses are on their part recorded when they are incurred. For instance, income will be recorded when a company bills its owners and not when the time when the funds are actually received. This also happens to expenses. If the management approves a supply contract worth $100,000, the expense will be posted even if the money might not be moved out of the bank for a long while afterwards. In accrual accounting, the main objective is to achieve an accurate reporting of income for every accounting period irrespective of the duration, for instance annual, monthly or quarterly. This objective is attained in two main ways. The first is recognition of revenue at its point of earning, for instance the delivery of products finishing of service work irrespective of the cash exchange’s timing. It further records the revenues during the same times as the associated expenses which were paid for in revenue generation. The main overriding principle in full accrual accounting is the matching principle in which expenses are documented during the same time when revenues related to them are recognized (Rosen, 2005). Black (2008) explains that modified accrual accounting on its part is a mixture of the accrual and cash methods. Firms which use modified accrual will for instance record every assessment when it is due, but at the same time record its expenses only when paid. It is also referred to as expenditure basis accounting. It recognizes events and transactions when they occur, and does not consider the time when cash is received or paid. In its case however, no costs that might be consumed later on are deferred. Physical assets that can offer service in future end up being written off during the period when they were acquired. The modified accrual method differs in that the revenue is taken note of at the time when it is measurable and available, while expenditures are identified at the time when liabilities are incurred. However, there are instances when this does not apply even in the modified method. For instance, the provision may be excluded when the inventories of supplies and materials may be taken to be expenditures either at the time of being used or being purchased. This also applies when there is an interest on special and general assessment in a long-term debt which is recognized on the date when it is due (Weygandt et al., 2010). According to Needles et al. (2011), there is a numerical mismatch between a cash budget and full accrual budget in any given period. The full accrual budget will include values that will imply no receipt or payment of cash in a given period. It will therefore be used in the estimation of the expenses and revenues for a given duration so as to find out how much profit may be expected from the business. On the other hand, a cash budget only plans for goods or services that have implied an inflow or outflow or cash into the firm. The idea will be to confirm if or not enough cash is available for the business to sustain its operations and if it will be able to extend any credit to customers without the possibility of ending up with liquidity problems. In modified accrual, when there is no applicable modification then the accounts payable are acknowledged in the period when the entity comes up as a liability. On the other hand, in full accrual budgeting, payables are recognized during the period in which the liability is incurred by the government or such entity. In addition, long term liabilities in modified accrual are recognized with the maturing of the liability or as much as it is expected that the liability is likely to be liquidated using available expendable financial resources. Full accrual on the other hand recognizes the liability during the time when it is incurred. For non-current long-term liabilities, in modified accrual the portion which fails to meet the criteria to be recognized as a possible current liability ends up being a non-current liability in the long-term. Full accrual on its part recognizes the liabilities during the time the liability is incurred (Black, 2008). Rosen (2005) adds that for revenues, modified accrual recognizes government fund revenues when the cash is acquired at the time or soon after the year ends and when the money is earned and noted to be both available and measurable. In contrast, modified accrual recognizes the revenue as at the time when the revenue is earned and is measurable. The aspect of availability is not an issue. Lastly, for modified accrual, when there is no applicable modification, all expenditure is recognized during the time in which it is made or becomes the subject of accrual. An accrual is recorded when it is expected to consume financial resources which are expendable. In full accrual, the expenditures get recognition at the time when the liability is incurred. Modified accrual and full accrual accounting have a shared accounting framework. However, they differ only slightly because of the fact that there is a variation in the time span between asset and goods acquisition and their use. Under the modified form of accrual accounting, all the supplies involved as considered to be consumed while assets are written off when they are acquired. In full accrual accounting, any changes noted in inventories are documented and any assets are depreciated progressively in line with their use (Rabin, 1992). Transparency as an Issue in Financial Management Transparency is often used in reference to financial statements that are of high quality. Its synonyms that are also applicable to financial reporting include, candid, clear and easily understandable. In financial reporting, the term relates to the publicization of corporate governance and also timely provision of information relating to the performance of companies. It is defined as a state within which all the necessary information relating to business is made freely and fully available to members of the public. The presence of transparency in markets is a positive attribute because it leads to greater efficiency (Weygandt et al., 2010). Throughout history, there have been high-profile cases of financial fraud for instance those at Tyco and Enron. These have shown the world that managers can at times use complexity in business structures and fuzzy financials in hiding unpleasant financial news. The absence of transparency is therefore a possible avenue for disaster in business and investment. Calls for transparency have therefore been growing, both in public and private sectors (Mallin, 2007). A good example to understand transparency in accounting is the case of two companies, X and Y which have an equal market capitalization, financial leverage and market-risk exposure. If X is a single-business firm with simple financial statements and Y has several subsidiaries and businesses that produce complex reports, Y will tend to be less valued by investors because of its opaque and complex financial statements. According to Rosen (2005), less information implies less certainty on the investors’ side. Where financial statements are not transparent, investors will not be sure about the company’s true risk and real fundamentals. It is hard to evaluate the performance of a company's investment in case investments take place in holding companies that are not visible. Limited transparency can also camouflage the indebtedness of a company and therefore investors are unable to estimate its stability. Transparency always pays in financial management. The market always grants greater value to firms which have upfront information for analysts and investors. Companies that offer more disclosure gain more trust from their investors. Reliable and relevant information implies less risk to investors and therefore a reduced cost of capital. This in turn leads to higher levels of valuations. In addition, companies that have good results tend to release their earnings much earlier as they have nothing to hide. It is in the firm’s interest therefore to uphold transparency in its information, as in this way the market is likely to raise its fair value (Black, 2008). Possible Reporting Distortions in Reporting Cash accounting fails to allow for the tracking of actual dates for purchases and sales, leading to the possibility of difficulties for instance in firms which do not get immediate payment for goods or those which have bills outstanding and yet to be settled. In addition, because there is no comprehensive recording of partial payments, the balance sheet produced may fail to show all the monies due. Weygandt et al (2010) explain that cash accounts may lead to distortion in financial reporting as for instance, if management approves a supply contract worth $ 20,000, the obligation will not appear on the statement. Because of this, the financial statement will end up showing that a company had surplus figures while in reality, there might be an overdraft. A cash budget may be vulnerable to manipulation for instance where a large payout is made just a day or two before the end of a financial period. This may mislead because it will cut down cash flows of one period while inflating those for the next. Even in a case where the company’s operations may be experiencing losses, this might create a false positive flow of cash. Similarly, if payments are made early, there are negative cash flows recorded even where profitability is achieved (Lynch & Martin, 1993). Black (2008) explains that because expense and revenue recognition in cash accounting is dependent on the timing of different disbursements and cash receipts, it can at times create a misrepresentation of the firm’s financial health. A good example is the case of a company which makes an annual rent payment of $12,000 during the month of January, rather than monthly payments of $1,000. Cash accounting will consider the $12,000 as January’s rent expense while the remaining 11 months will have a zero expense on the rent item. In the same way, in case a firm sells goods worth $800 in March but the buyer only deposits $100, only the $100 appears as the month’s revenue while the remaining $700 is suspended until payment is received. A cash budget can lead to distortions because a cash inflow does not represent a profit. Cash inflows from fines, security deposits, selling off capital assets or some other non-sustainable and one-off activity does not necessarily signify a reliable and continuing source of revenue. In some instances, the sale of items that have extended credit periods will lead to a much greater profit in the long run, in addition to being able to cover the interest related to the securing of short-term loans so as to cover immediate financial obligations (Needles et al., 2011). Rosen (2005) explains that on the other hand, accrual accounting will recognize the expenses and incomes in a given period irrespective of whether or not money will change hands. For instance, if a contractor finishes up all the work given to him during April and provides an invoice to the government on May 1, the contractor will count the amount received from the contract for April because it was the month during which it was earned even if payment remains pending for some duration of time. Many firms adopt the accrual method. However, it is characterized by a possible distortion related to the inability of businesses to ensure accurate tracking of cash flows. This may lead to situations where even when a company might be reporting high revenues, this will not necessarily mean that it retains cash balances which will add up to the revenues expected. Management Advisory Board (1997) confirms that there are possible distortions in the modified accrual method. Because reporting of expenses is done using a cash basis, the monthly financial reports at times end up being misleading. For instance, if the government accepts to pay $ 10,000 for a contract, this will not come up during the month’s financial report until when the company will issue a cheque to the contractor. Consequently, the management might think that it still has a lot of funds while in reality the contract’s obligation has not yet been accounted for. Depending on the kind of valuation applied and type of inventories being assessed, there may also be distortions in the Business Inventory Asset Accounts. The value attached to inventory valuation can also generate different kinds of tax liabilities as government agencies for instance include inventory valuation in establishing payments of corporate tax. There is the possibility of distortions occurring within the accounting reports due to extraordinary financial items or business activities. There may be the need for companies to write off some financial items which are reflective of some non-cash transactions for the company. Writing off extraordinary non-cash write-offs will usually have an effect on the organization’s net income in the course of the accounting period when the write-off is made. For instance, if a company reports $150,000 as its net income on the yearly income statement, a possible $200,000 non-cash write-off will imply a $50,000 net loss (Mallin, 2007). References Black, G. (2008). Introduction to Accounting and Finance. New York: Pearson Education Limited Clare, R. (1994). Accrual Accounting: Fad or Necessity? Directions in Government. Vol. 8(4): 30-32 Needles, B, Powers, M and Crosson, S. (2011). Financial and Managerial Accounting. Mason: South-Western Cengage Learning Lynch, T. and Martin, L. (1993). Handbook of Comparative Public Budgeting and Financial Management. New York: Marcel Dekker Mallin, C. (2007). Corporate Governance. Oxford: Oxford University Press Management Advisory Board (1997). Beyond Bean Counting: Effective Financial Management in the APS - 1998 and Beyond. Canberra: AGPS Rabin, J. (1992). Handbook of Public Budgeting. New York: Marcel Dekker Rosen, H. (2005). Public Finance. Beijing: Tsinghua University Press Weygandt, J, Kimmel, P and Kieso, D. (2010). Accounting Principles. London: John Wiley and Sons Read More