Cash versus Accrual Accounting - Coursework Example

Cash vs. Accrual Accounting Introduction Cash basis of accounting and accrual basis of accounting are two systems that are acceptable under comprehensive basis of accounting. In this write up a comparative analysis has been undertaken of the two systems of accounting with respect to recognition of business transactions. The analysis also discusses the comparative advantages and disadvantages of the two systems and the impact thereof on the financial statement presentations. An effort has also been made to discuss the situation where under cash basis accounting is used to prepare accrual based financial systems. Comparative analysis Cash basis of accounting is one of comprehensive basis of accounting. Under the cash basis of accounting, only those transactions that result from cash receipts and cash disbursements are presented in the books of accounts. Under cash basis of accounting revenue and expenses are recognized when revenue is realized and expenses are paid for. In a simple business transactions the expenses when incurred near to the time of sales are realized in cash, the cash basis of accounting provide more accurate and precise information about the business affairs during the accounting period. The reason is that transaction more or less gets completed when cash is received or paid for. Most companies prepare their financial statements in conformity with GAAP principles on an accrual basis. As a general rule it is agreed that application of accrual basis provides more meaningful financial statements. Users of financial information will find it useful to know the actual earnings for the entity, the resources available to the company, and the claims against those resources. Accrual accounting provides a more accurate measure of earnings than other basis of accountings that are acceptable and treated as comprehensive basis of accounting. Under the accrual basis: Revenues are recognized when they are earned, regardless of when they are received. Under the matching concept that is treated as part of accrual accounting, expenses are recognized when they are incurred regardless of when they are paid. Gains and losses resulting from the incidental transactions of the enterprise are recognized in the periods in which they occur. In keeping with the concept of conservatism, the risks inherent in being in business are considered. Accrual accounting provides a more accurate measure of financial position. Under the accrual basis: Resources are included even though they may not have been converted into cash. This brings in the actual earnings of the entity for the period under consideration. The most important thing is that cash payments that will provide future benefits are listed as resources. For example payments for acquiring assets are not treated as expenses in order to suppress the earnings. Depreciation on assets is treated as expenditure as per use and rules provided under the GAAP. Information is provided about claims against resources, whether for expenses incurred or other obligations of the company that may require future cash outflow. This makes the financial statements more realistic and useful as user gets pre information about future outflows. Simplicity is perhaps the biggest advantage of cash basis of accounts. Even non- accountants follow this accounting system. All that is required to maintain accounts are deposit receipts and cheque book counterfoils. That is the reason that most of non- profit organizations use cash basis of accounting. ‘Another reason organizations often keep records on a cash basis is that they feel uneasy about considering a pledge receivable as income until the cash is in the bank. These organizations frequently pay their bills promptly and, at the end of the period, have very little in the way of unpaid obligations. With respect to unrecorded income, they also point out that, because they consistently follow this method of accounting from year to year, the net effect on income in one year is not material. Last year’s unrecorded income is collected this year and tends to offset this year’s income. The advocates of cash basis say, therefore, that they are being conservative by using this approach.’(Malvern J Gross, page 26)i Advocates of cash basis also stress that there is no need for accountants to do additional work for preparing separately a cash flow statement. Accounting of cash basis receipts and payments give a more accurate idea about the cash flow status of historical accounting. The cash basis accounts itself become basis for preparation of a future cash flow to enable the entity to plan for future. Under this system there is no need for preparing additional cash flow statement for period for which income statement and balance sheet are being prepared. There are no hassles of making a number of adjustments to accrual accounting to arrive at cash in flow and cash that out flowed during the period. It is believed that normally accounts prepared under cash basis are not materially different from accounts prepared on accrual basis when there are no credit sales or purchases or the quantum of such credit sales and purchase is hardly considerable. But when scales of such differences are large accounting system does make a lot of difference. Not only receivable matters but adjustments on account of inventories make noticeable different results of the operations of the business of the entity. ‘The disadvantage of the cash basis system is that for any particular short period of time operating results can be greatly distorted from economic reality. The distortions usually result from transactions occurring near the end of accounting periods.’ (Michael Sack Elmaleh and Jeremy David Delavel Willis, page 40)ii Moreover, cash basis accounting does not recognize assets and liabilities that do not result from cash transactions. Further accounts receivable, accounts payable and other accrued transaction remain unreported. Such ignorance of accrual transactions does not bring the real earnings or losses to the fore. Moreover, cash basis of accounting permits the manipulation of results of business at the behest of management when cash receipts or payments are deliberately delayed beyond or preceded before the year or accounting period ending. It is remarked some times that cash basis accounting is half cooked food that is not good for the health of the business. Financial reporting make basis for serious business decisions and when those are based on half cooked accounting, there is always a danger of wrong decision making affecting the future of the business. This certainly makes financial statement prepared on cash basis incomplete and lacking in providing needed information to users of financial statements. ‘For organizations that choose to present their financial statements on cash basis a question arises as to what, if any, notes and other disclosures should be made in the financial statements. Generally accepted accounting principles require many different disclosures in accrual- basis statements, but mostly silent about the requirements to make such disclosures in cash basis statements. Some guidance, however, has recently been issued that will assist financial statement preparers (and auditors) in determining the adequacy of disclosures for cash basis financial statements.’(Richard F Larkin and Marie DiTommaso, page 11)iii It is not that accrual system is all good things. This system is also crippled with certain limitations. Accrual method depicts the flow of income and its liabilities more accurately, but the system lacks the ability to show cash balance position. There may be high sales but the entity remains unaware about their cash reserves. High sales in ledger do not necessarily mean overflowing cash balances. Those might be empty if the cash is not realized in due course tending reversal of transactions to attain the original work. That is why accountant is a busy person without making and difference to cash kitty of the entity. Whatever remains the status of cash kitty, the accrual system is a better indicator of ability as compared to cash system. ‘The accounting profession generally supports the view expressed by Financial Accounting Standard Board (FASB) in the USA that accrual accounting provides a better indication of an enterprise’s present and continuing ability to generate favorable cash flows than information limited to the financial aspects of cash receipts and payments. The IASC supported the FASB view in 1989 when it stated that financial statements prepared on an accrual basis inform users not only of past transactions involving the payments and receipts of cash, but also the obligation to pay in future, and they provide the type of information about past transactions and other events that is most useful in making economic decisions.’(Jamie Elliot, page 24)iv There are certain matters that greatly impacted by the method of accounting being followed the organization. For example income for the tax year is directly affected by the adopted method of accounting. When cash basis is adopted by the company as its accounting method then expenses incurred will not be allowed for computing taxable income unless those are paid in that tax year. Though ultimately the impact of taxation gets neutralized provided the tax rates remain the same. Otherwise the company will be paying more or less taxes depending upon the fluctuation in tax rates in the coming tax year. ‘A firm generally can use whichever accounting method it chooses, though regular corporation form of business cannot use of the cash method. The cash method generally cannot be used to calculate income (loss) for tax purposes by any form of business, if that business maintains an inventory or if the business uses inventory as the means of arriving at the business’s income.’ (Christine M Piotrowsky, page 210)v Some companies will maintain books and records on a cash basis, but prepare financial statements on an accrual basis. When this is the case, a trial balance will be prepared from the books and records and adjusting entries will be made. Some of the most typical entries will include adjustments for receivables and payables, prepayments, and inventory. In preparing such accrual basis financial statements from cash basis records, it is important to determine if an appropriate entry was made to recognize accruals for the previous period. If it was made, the current period entry will consist of an adjustment of the accrual item and the related income statement amount. If an item was not recognized in the previous period, an adjustment will be necessary to recognize the effects of the item on the beginning balance of retained earnings as well as current period’s income statement amount. So comparatively speaking, cash basis of accounting has the advantage of being the easier method of the two. Cash basis of accounting make it convenient to keep record on single entry system, which is not there on accrual basis of accounting. Further taxes are calculated and paid only on the basis of actual revenue received during the tax year. The benefit of accrual basis is that the system approximates the revenue and expenses to the actual period during which those occur or incurred. Thus accrual basis of accounting become a better tool to analyze the comparative performance of an entity during two accounting periods. The accrual basis also uses only double entry system of accounting which is a perfect accounting system. But the taxes paid on income calculated under accrual system are on basis of revenue that might not have been received. The deficiencies of cash system are that revenue and expenses recorded do not match with actual period during which such transactions take place. Conclusion The above comparative analysis depicts that accrual basis is more comprehensive and better system of accounting when compared to cash basis of accounting. That is reasons accrual system is promoted and recommended by various accounting authorities, particularly those responsible for issuing GAAP pronunciations in different parts of the world as well as International Accounting Standard Board (IASB). Word Count for 8 pages: 2012 References Read More