Cash Basis Accounting vs Accrual Accounting - Assignment Example

CASH BASIS ACCOUNTING VS ACCRUAL ACCOUNTING Name: Professor: Institution: Course: 1.1 Introduction Accounting systems and reporting systems are very important for financial accountability, managing budgets and decision making. In the past, the main purpose of government accounting was to ensure proper use of public money and for this reason just a cash budget was enough. However, accrual accounting has gained great importance in many countries to ensure financial compliance as well as operational efficiency. To achieve this, businesses have to fully report their financial position including the liabilities and assets as well assess the operation costs which should include use of assets. Accounting systems are classified into four types namely; cash, modified cash, full accrual, and modified accrual (Michael et al, 2005) . They systems refer to the accounting principles which establish when events or transactions should be recognized for financial reporting. However, these accounting systems are somehow schematic; for instance, in nations with a cash based system, their accounting has two approaches, i.e. appropriation or budgetary accounting that tracks appropriations at different levels of the expenditure cycle and cash basis accounting that recognizes an event or transaction only when cash is disbursed. Therefore, accounting requirements depend on agencies and programs, a full accrual accounting system can be appropriate for an agency which has commercial activities or delivers services while for other agencies budgetary and cash based system can be satisfactory (Michael et al, 2005). This report will focus on the differences between these accounting systems, issues of transparency for each system and Provide examples of reporting distortions or discrepancies when using specific accounting tools. 2.0 Differences between modified accrual, full accrual, and cash budget. A cash based budget refers to budget where most of the appropriations are on a cash basis which measures the flow of cash resources (Lynch & Martin, 1993). In the cash based budget, appropriations define annual commitment and limits of payment i.e. financial obligation are met within the fiscal year and the annual tranche of multiyear commitments. Therefore, this budget fits well the need for expenditure control and compliance. This system only recognizes events and transactions when cash is paid or received i.e. as compared to other accounting systems (modified accrual and full accrual) in cash basis accounting, expenses and revenues are only recorded when they are paid no matter when they were actually invoiced (Lynch & Martin, 1993). Therefore, financial statements generated under this accounting system cover cash disbursements, cash receipts, and opening and closing cash balances. This system is mostly used by corporate entities as compared federal agencies and governments which often use modified accrual based system. Under the cash budget where appropriations are on cash basis accounting focuses on cash rather than credit (Michael et al, 2010). According to principles of business valuation, a company’s value is measured based on the level of cash it has. Therefore, the cash based accounting system demonstrates the future growth potential of a company and its liquidity presents an accurate picture of the organization. Moreover, this system removes uncertainties organizations may face, including dealing with bad debts since there is no credit there are no customer receivables in the accounts that might default in the future (Patrick et al, 2012). The modified accrual basis of accounting also known as expenditure basis recognizes events and transactions when they occur no matter when cash is received or paid (Lacoma , 2011) . Government agencies use this accounting system irrespective of the fund type (Lynch & Martin, 1993). This accounting system combines element of full accrual method with cash base accounting (Lacoma , 2011). Under modified accrual, revenues are recognized in the financial statement only when this revenue becomes “available.” In this case, the term revenue refers to measurable revenue against which cash may be paid in the twelve months succeeding the even or transaction (Lacoma , 2011). On the other hand, the period of recognition of expenses depends on the period in which the liability arises and whose payment the agency must make within the next 12 months. Under this method, income earned is recorder the same as full accrual accounting system but expenses are only recorded when they are paid. However, under this system no deferral of costs that will be incurred in the future. Company’s physical assets which will offer services in the future are written off in the period that they were acquired (Patrick et al, 2012). Modified accrual and full accrual accounting systems are have the same accounting framework but a major difference lies in the period between acquisition of assets and goods and their utilization. Under modified system, assets are written off as soon as they are acquired and supplies are considered consumed. However, full accrual accounting recognizes changes in stocks and physical assets are progressively depreciated according to their useful life. Compared with cash accounting system, modified accrual accounting “offers an advantage of recognizing expenditure at the verification stage giving an adequate framework for assessing arrears and liabilities. There is a variety of modified accrual accounting systems, depending on the treatment of superannuation liabilities, depreciation, and inventories (Patrick et al, 2012) .” Therefore, the financial statements generated under this system cover financial assets, revenues, net financial resources, expenditures, and liabilities. Just like modified accrual accounting system, the full accrual accounting system recognizes events and transaction when they occur irrespective of whether the cash is received or paid. However, full accrual system tracks transactions only not cash flow (Lacoma , 2011). Under this accounting system, revenues reflect the amount that was earned during the period regardless to whether this amount was collected and expenses reflect the amount of commodities and services consumed during the year regardless of whether they are paid for in that period. On the other hand, the cost of the company’s assets are recognized and deferred when they are used to provide services (Carlin, 2005). The expenses recognized by the full accrual accounting system are costs of goods and services consumed as well as any decrease of assets or increase of liability over the accounting period and this should not be confused with actual expenditures (Michael et al, 2005) . Financial statement generated under this accounting system cover expense (including depreciation), revenues, assets (financial and physical), net assets, and liabilities. The following tables summarize the differences between full accrual and modified accrual accounting systems. Modified accrual Full accrual Stock Modified accrual uses either the purchase method or the consumption method Full accrual uses consumption method Capital asset acquisition This accounting system Recognize the expenditure at the acquisition date Recognize the cost of the asset and depreciate the value over the expected useful life of the asset Expenditure Expenditures are recognized in the period in which they are expended or when they are subject to accrual and these accruals are recorded when they are expected to use expendable financial resources Fund expenditures are recognized in the period in which the entity incurs a liability. Adjustments may be needed to ensure the matching principle is followed Revenue modified recognize revenues as cash is received during or soon after the end of the year and when it is earned and both measurable and available Recognize the revenue in the period in which the entity earns the revenue and it is measurable, availability is not a factor Long-term liabilities – current portion Recognizes a liability to the extent that liability is expected to be liquidated with expendable available financial resources Recognize the liability in the period in which the entity incurs the liability Long-term liability- Noncurrent The portion that does not meet the criteria for recognition as a current liability is a non-current long-term liability Recognize the liability in the period in which the entity incurs the liability Accounts payable In the absence of an applicable modification, accounts payable are recognized in the period in which the entity incurs the liability Recognize a payable in the period in which the entity incurs the liability Source: Author (2012) The example below shows the broad differences between the different types of accounting Accounting period January-December Commitment, October 2010. Order of supplies 1100 Delivery/verification, November 2010:$ 1000 Partial payment, December 2011: $800 Supplies used in 2011: $700 Inventory, December 31, 2011: $300 Depreciation of assets of the department, 2011: $137 Account Debit Credit Date Cash system Payment Budget operations 800 2010 Cash-Bank 800 2010 Modified accrual Verification Budget operations 1000 2010 Liability 1000 2010 Payment Liability 800 2010 Cash-Bank 800 2010 Full accrual Verification Budget operations 1000 2010 Liability 1000 2010 Payment Budget operations 800 2010 Cash-Bank 800 2010 Supplies Budget operation 1000 2011 Expenses 700 2011 Inventories 300 2011 Depreciation Assets 137 2011 Expenses 137 2011 Commitment: 1100 (2011) (should be registered whatever the basis of accounting) Source: Author (2012) 3.0 Issues of transparency when using the accounting system For financial information to be useful, it has to be comparable, consistent, reliable and transparent. One way that a company can achieve transparency in their reporting is through preparing their information using high quality accounting standards. Transparency helps creditors, market participants and investors to determine the condition of a company financially. Transparency increase market fairness and enables board of governors to determine the effectiveness of management and be in a position to take corrective actions and in extreme cases address the worsening condition of the company. If the reports are transparent, investors, creditors and even other users of financial statements will find the reports more reliable and consistent. The accounting standards give a framework whose main intention is to ensure that the information provides is capable of making informed decisions. Whichever basis of accounting a company adopts, cash basis or accrual accounting, for transparency to be there in the accounting system, all payments done over a particular period of time must be reported according to the expenditure classification system which should include payments that related to expenses that were made in the previous period. As discussed above, cash basis recognizes transaction only when cash Is received regardless of when the transaction took place. We could agree that indeed cash basis of accounting is inadequate for most organizations and it does not offer transparency in financial reporting. However this could be a preferred method for a manager as this method will help him or her hide the real results of an operation through manipulating the firm’s cash flows. The company’s liabilities, accounts receivables as well as other assets are not displayed on the financial statement. The main issue with using cash basis is that liabilities as well as the assets are not recorded and for this reason they are hiiden from the users. On the other hand accrual accounting recognizes transactions when they arise. For instance if an organization buys goods on credit, they goods are recorded as credit purchases and are a liability to the company. Accrual accounting usually recognize assets and liabilities as opposes to expenses and revenue. Whenever an asset is acquired on credit, liability is transferred to the balance sheet and the asset or account payable is accrued. Naturally, it is expected that the balance sheet must balance and therefore omitting liability will offset the balances. Using “below-the-line accounts” will lead to issues of transparency as this may lead to offset budgeting. This problem is mainly experienced by developing countries which have poor governance and rely on pure cash basis of accounting. Accrual accounting basis can only be transparent if the members of the public are sufficiently informed about the foregoing issues. However this has not been achieved yet n developing countries and even in the developed countries. Modified accrual accounting gives a suitable frame work for accounting for liabilities and in addition, it ensures that all the contingent liabilities are disclosed in the supplementary notes. Transparency in cash accounting systems could be improved by developing an implementation approach which will gradually improve the existing cash accounting systems via comprehensive coverage. Reporting distortions or discrepancies when using accrual versus cash accounting For purposes of accounting, the best method is said to be accrual accounting regardless of the type of business. Cash accounting is prone to distorting the operations of a business and presents the income incorrectly. As discussed above, cash accounting acknowledges income when the payment is received while accrual accounting acknowledges income immediately the goods are shipped or as soon as they deliver the services regardless of whether they have received the payment or not. Under cash accounting, expenses are acknowledged when they are paid for and not when they are incurred while accrual accounting acknowledges expenses as soon as the business incurs them. An example of this is, if a company collects little or no debts from the debtors but pays lots of debts from its creditors, under the cash accounting system, expenses have been incurred with no receipt of cash. On the other hand, if the company had collected more debts from its debtors but paid little to its creditors, they would have lots of income. This two cases show distortion of what really happened (Elmaleh, 2012). Cash accounting systems usually distorts the financial reports to the external users as they seek to understand the financial health of the company. An example of this is a company that is in a construction business and wins a tender for remodeling project worth $20,000. The company then orders $8,000 raw material on credit. The company starts working on the project on April 1st and is paid a deposit of $5000 to start working on the project. If the company is using cash basis accounting, it will appear as if the company has received $5000 as income for April while in real sense you have a shortage of $3000 because he has not yet paid for the supplies. Although the owners of the company know very well that they have not yet made any income in the month of April, the company’s financial statement will indicate that a profit was made in the month of April. The financial report for the subsequent months would reflect reduction of income when the raw materials are eventually paid for. If the company was simultaneously conducting several projects, then cash accounting system would eventually distort the real financial reports of the company. The accrual on the other hand cause discrepancies and distortions in that they do not take account of delays. An asset like in the example above could have been purchased but not yet paid for. This requires the business to keep track of the book values as well as the real values of the incomes as well as its expenses. This recording of expenses as they are incurred could blind the manager as it makes it very hard for them to identify which projects they have or have not yet approved in their budgets if the expenses are entered when the checks clear. Accrual accounting also involves a lot of bookkeeping as compared to cash accounting which only requires the company to record the transaction once when a payment is made or received. For accrual accounting, the transactions must be recorded on the date of the sale as well as when the payment is made. In the example above about the $20,000 construction project, the company would have to record this revenue as soon as the contract was sealed and the cost of raw materials when they were purchased. The labour expense of the contact would charge when the contract is sealed. The income would not be captured in the reports when it actually happened. Unscrupulous company managers may decide to delay the expenses or even record the revenues correctly so as to force incomes to what they want. This will result to discrepancies which are a risk to creditors and lenders (Lacoma, 2011). References Elmaleh, M.S (2012) Bases of Accounting Retrieved on 16th March 2012 from http://www.understand-accounting.net/basesofaccounting.html Carlin, T.M. (2005), debating the impact of accrual accounting and reporting in the public sector; Financial Accountability & Management, 21(3) Lacoma T (2011) Differences in Modified Vs. Accrual Accounting, Retrieved on 16th March 2012 form http://www.ehow.com/info_8636408_differences-modified-vs-accrual-accounting.html Lynch, T.D., & Martin, L.L. (1993). Handbook of comparative public budgeting and financial management, New York: Marcel Dekker. (Dixson 336/L987h) Michael H. Granof, Saleha B. Khumawala (2010) Government and Not-for-Profit Accounting Concepts and Practices Patrick R. Delaney, O. Ray Whittington (2012) Wiley CPA Exam Review 2012, Financial Accounting and Reporting, Wiley publishers, New York: USA SCORE L (2010) Cash vs Accrual Accounting Pros & Cons, Retrieved on 16th March 2012 form http://scorelancaster.wordpress.com/2010/02/18/cash-vs-accrual-accounting-pros-cons/ Read More