Cash Accounting vs. Accounting - Research Paper Example

 Cash Accounting vs. Accounting Introduction Accounting is a form of reporting the business and other transactions of an entity or a person in order to formulate an assessment of its earnings during a period, and also to arrive at its financial status on a particular date. Different basis for accountancy are prevalent to recognize, record, and report the transactions. Commonly used accounting basis of accountancy are Cash basis and Accrual basis. Cash is considered bloodline for a business and that is why cash inflows and cash outflows are treated with utmost care. Based on this is the process of cash flow accounting. Under cash flow accounting only transactions that result from cash inflow (i.e. receipts) and cash outflow (i.e. disbursements) are recognized and reported. The other basis of accountancy that is practiced widely is accrual accounting. Most companies prepare their financial statement in conformity with generally accepted accounting principles that advocate accrual basis of accountancy. Majority of businesses in different nations do not fall under any organized sector. Those dealing in unorganized sector believe that cash and other properties in possession of an entity determine the value of its business. They are not sure about outstanding transactions, as according to them recoveries always remain doubtful till there is cash inflow. Hence they believe that cash accounting brings out the real position of an entity with regards to its earnings and financial position. On the other hand organized sector formulate accounts as per applicable GAAP. Even though GAAP recognize cash transactions as in cash basis of accountancy, the accounting standards formulators promote accrual basis of accountancy. Accounting standards formulated by various accounting bodies insist that accrual accounting is the real accounting to formulate an opinion about true earnings and financial position of an entity. At the same time it is also true that cash basis of accountancy is largely practiced and recognized. There are many merits and demerits of each basis of accountancy. Therefore the issue under consideration is as to which accounting system provides better and complete information to the users of financial statements. General investors get information from annual reports about return on their investments. They are not bothered about earning per share. Instead they are concerned about dividend declared on shares representing their investments that they are going to receive in cash. Cash inflow is important to them. On the other hand tax authorities consider declared dividends as income of shareholders, whether cash on such declaration has been disbursed or not. An in depth study hereinafter will reveal and determine as to cash basis of accountancy provide better information to the users than the accrual accounting, and if not where does cash accounting stands in comparison to accrual accounting . Theory (Literature Review) Cash accounting can be termed as simple accounting technique. Revenue is recorded when cash is received and deposit is made. It does not make any difference when the sale occurred in respect of that deposit. Similarly expenditures are recognized when cheques are made out. Therefore, cash inflow and cash outflow are the basis for recognition, recording, and reporting of any transaction under cash accountancy system. Here it is necessary to understand the meaning of the term cash. As per IAS 7, “Cash and cash equivalents comprise cash on hand and demand deposit, together with short- term, highly liquid investments that are readily convertible to a known amount of cash, and that are subject to insignificant risks of change in value.”(Delloite, IAS 7, paragraph 7)i That implies that cash comprises cash in hand, with bank, and short term financial instrument. The implication of term cash basis is that the cash accounting system will recognize transactions and other events that are received and paid for in cash and its equivalents. “Cash basis accounting is a recognized ‘other comprehensive basis of accounting’, and an independent auditor may opine on cash basis statements as long as the statements (and the auditor’s opinion letter) clearly indicate that the cash basis financial statements are not presented in accordance with generally accepted accounting principles,”(Richard F. Larkin and Marie DiTommaso, page 9)ii Cash accounting is not acceptable to accounting standard formulators. This is mainly because cash accounting does not recognize revenue when it is realized. In fact cash accounting consider recognition of revenue when revenue is received in cash. The recognition may not take place in the same financial year. For example if the payment of bill raised in October 2009 (assuming calendar year is the financial year) is received in February 2010 next year, then it will be recognized as sales for the year 2010 even though sales were realized in October 2009. Similarly expenditures are also recognized when those are actually paid for in cash and not when those are incurred. Cash basis of accounting has certain specific weaknesses as a basis of measuring performances for a specific accounting period. “Cash basis does not adequately match the costs of efforts required to generate inflows with the inflows themselves. Cash outflows of one period can relate to operating activities whose cash inflow occurred in preceding or succeeding periods. Second, the cash basis of accounting separates the recognition of revenue from the process of earning those revenues. A firm should recognize revenue when it has earned that revenue by delivering goods and services to customers, which often occur before it collects cash from those customers. Third, performance measured using the cash basis is sensitive to the timings of cash expenditure.” (Clyde P. Stickney, Roman L. Weil, and Katherine Schipper, page 28)iii Cash basis accounting lacks the ability of comparison. Revenue and expenditure of one accounting period are not comparable with revenue and expenditure recorded for another accounting period. The reason is that transactions under one accounting head may not be representative of the full accounting year. Accrual accounting, on the other hand, provides a more accurate measure of earnings than other basis of accountancy. Revenues are recognized when those are earned. It does not make any difference as to when those are received. Expenses are recognized when they are incurred, regardless of when they are paid. Gains and losses resulting from incidental transactions of the entity are recognized in the period in which they occur. Moreover, in keeping with the concept of conservatism, the risks inherent in being in business are considered. Accrual accounting also provides a more accurate measure of financial position. Resources are included, even though they may not have been converted into cash. Cash payments that will provide future benefits are listed as resources. Information is provided about claims against resources, whether for expenses incurred or other obligations of the company that may require future cash outflows. The “accrual basis of accounting matches revenue to the time period in which they are earned and matches expenses to the time period in which they are incurred. While it is more complex than cash basis accounting, it provides much more information about the business.” (Stan Snyder, page 1)iv It is clear that accrual basis support the matching principle of accountancy. Income statement for a period should reflect the result of performance during that period. This is possible only when all transaction relating to that accounting period are recognized, recorded, and processed. This is possible only in accrual basis of accounting and not in cash basis of accounting. Income statement can process the revenue and expenditure only when matching principle of accountancy is being followed. Moreover, “it should be noted that revenue does not necessarily mean receipt of cash and expenses does not automatically imply cash payment. Net income and net cash flow (cash receipts less cash payments) are different.” (Jae K. Shim and Joel G. Siegel, page 17)v Accrual accounting follows an accounting cycle to generate the its final output called financial statements. Accrual accounting follows the following basic steps in an accounting cycle in order to produce results of an accounting period and be ready to recognize, record, and process accounting transactions for the coming period: “1. Identifying, analyzing, and recording the effects of transactions on the accounting equations (financial statement accounts). 2. Identifying, analyzing and recording adjustment data. 3. Preparing financial statements.” (Carl S. Warren, page 101)vi Under accrual accounting adjustments are made following the matching system of accountancy, so that accurate financial results are reflected in the financial statements. That is why under accrual system of accounting records are required to be updated. This updating process is the process to follow the matching system of accountancy. Practice (from the literature) Even though cash accounting system is not recognized under GAAP, but the fact is that there is no general application of accrual accounting as well. Most small and medium size entities do not use accrual system. The cash basis is in vogue there. Even tax departments recognize cash accounting system. The big question here is whether present accounting system is ready for accrual accounting? Secondly are there users who understand accrual accounting? “Introduction of accrual accounting requires good project planning that addresses the conceptual, technical, and educational issues involved. A project timetable and regular monitoring is required, as well as the active involvement of senior staff. Without this involvement, they will neither understand nor use the financial statement prepared on an accrual basis.” (Nick Manning, Commonwealth Secretariat, and Sam Agere, chapter 6.3.3)vii The importance of Cash flow accounting cannot be ruled out even to meet the requirements of accounting standards, but the limitations of present cash flow accounting system comes in way for its acceptability with GAAP, as is clear from following: IAS 7 advocates direct method of preparation of cash flow statements. Idea is that cash inflows and outflows are shown directly to users of statements. By adding cash flow statement to the set of financial statements, the standard setters realize the importance of cash flows. But cash accounting system has not been recognized as part of GAAP. “It is important to point out, in order to understand the relevance of cash accounting system, that cash inflow and cash outflow can be respectively investigated in debit and credit sections of cash equivalent accounts, but there is no evidence of cash flow origin. In this way IAS 7’s requirements cannot be fulfilled, because net cash flow from operating activities must account for cash receipts from customers, cash paid to suppliers, cash paid to employees, cash paid for other operating expenses, interest paid, and income tax paid. IAS 7 highlights the fact that direct method provide much more useful information especially concerning future cash flow estimation, even if in order to report the above mentioned information, it is required to record specific cash inflows and outflows that present accounting system cannot record. Therefore companies often record cash transactions outside accounting information systems.” (Paolo Saracino, page 11-12)viii But as cash accounting system is incapable of providing complete data for the period, it is not possible to use such a system even for meeting present requirements of IAS7 and also for assessing the performances. Practically the strength of accrual system is matching concept. The advocates of cash accounting system believe that it is not necessary to follow matching concept under the prevalent major types of expenses. “This matching process is different for two major types of expenses. Expenses that arise in production of a product or services, called production costs, are recognized when the product or service is delivered. All product costs remain on the balance sheet as inventory until the products are sold, at which time they are transferred into the income statement as cost of goods sold (COGS). The other type of expenses is called period costs. Some period costs relate to marketing the product or service and are matched with revenues when revenue, when the revenue to which they relate are recognized. Other period costs, such as administrative expenses, do not directly relate to production or sale of product or services. They are expensed in the period they occur, which is not necessary when cash outflow occur.” (Wild, page 77)ix Accordingly there is elasticity of adoption of matching concept with cash accounting system as well, not in its present shape but in a modified form. Application of Theory to Practice Supporters of cash basis of accounting assign practical reasons for cash basis accounting. They insist that published annual reports carry income statements on accrual basis carry display picture of earnings resulting from smoothened cash flows (as future cash flows are also considered in accrual method). “If earning figures continue to be published, there will be a tendency by some investors to predict future earnings and use them directly in decision making rather than to convert future earnings into future cash flows. This step will cause serious errors in the decision made.”(L S Porwal, page 435)x Factually accrual accounting encompasses cash accounting in many ways. There is consideration of future cash flows besides the historical cash flows. “Accrual basis of accounting thus allocates (recognizes as revenue and expense) many transactions and events producing cash flows to time periods other than those in which cash flows occur. Accrual accounting principles are, fundamentally, the decision rules that tell prepares of financial statements when to recognize revenue and expense consequences of cash flows and other events.”(White, page 32)xi Nothing is left out in accrual accounting, and difference of transactions and actual flows are recognized as assets and liabilities. These days IFRSs are stressing the use of fair value. This promotes impairment theory where under eventual losses are written off as losses for the accounting period under consideration. This undermines the importance of accrual basis of accounting, as those losses do not belong to the accounting period under consideration. IFRSs and other standards are creating a hypothetical scenario of future losses as losses for current period, as impairment losses do no occur but predicted in the current period. If an entity is booking artificial losses under the cover of impairment losses, it may have to book gains or further losses when the actual transaction of sales of asset takes place. In a way it is an artificial presentation of financial statements using accrual basis. Cash accounting strictly avoid such a happening, as transactions are measured by the quantum of actual cash flows. “Changes in market values of assets and liabilities may occur over a number of periods, they are recognized in income either in period of sale or disposal or when certain impairment criteria are met. The result is current period income that may be distorted and may not be indicative of normal earning power.” (White, page 32)xii Conventional reporting using accrual basis provide information regarding financial position (i.e. balance sheet), performance analysis (i.e. income statement), and the financial conduct (i.e. cash flow statement) of the entity. These are very important and informatory reports. Still something important is missing in the annual reports of the companies. There is no information with regard to total productivity of the company. There is no information as to the shares of stakeholders, workers, and the authorities. The users need such value added information. “Value added refers to the increase in wealth generated by the productive use of the firm’s resources before its allocation among shareholders, bondholders, workers, and the government. Value added, the final return earned by the shareholders, refers to the total return earned by the team of workers, capital providers, and the government.” (Ahmed Riahi- Belkaoui, page 73)xiii Accrual accounting is considered as superior form of accounting, but it does not provide value added services in its present form. Many believe that allocation of revenues and expenses is arbitrary. Take the case of prepaid expenses being treated as assets only to enhance arbitrarily the net worth of the entity. Cash basis advocates feel that a false sense of security is being created by accrual basis by allocating revenue and expenses on arbitrary basis. Moreover the problems relating to income determination and assets valuation are formidable. To an extent these problems can be sorted out by accountancy called “Cash Flow basis of accounting”. Cash Flow basis of accounting is different from cash basis accounting. As per Ahmed Riahi- Belkaoui (page 73)xiv “The cash flow basis of accounting means recording not only the cash receipts and disbursement of the period (the cash basis of accounting), but also the future cash flows owed to or by the firm as a result of selling and transferring titles to certain goods.” Though future cash flows are being considered by accrual accounting but it need modifications to include extra features that validate information for the users of statements. Conclusion Cash accounting is based on historical cash flows. In the process, it ignores a number of transactions that occurred during the accounting period. This renders the income statement and balance sheet prepared on cash basis as incomplete documents not the true representative transactions that occurred during the accounting period. Accrual accounting is an extension of matching principle of accountancy. Allocations are made matching expenses with revenue for the current period. The differences between total value of transactions and historical cash flows are reflected as assets and liabilities in the balance sheet. But adoption of accrual accounting is a complex task. Users these days expect a number of additional information than provided through income statement, balance sheet, and cash flow statement. A value added statement is required and that is possible when value added accountancy is in practice. For example fair value of assets and liabilities depicted as per accounting standards can only be the best estimation and not a authenticated value. Using merely such estimations, a large scale distortion can be made in the statements. Accordingly an authenticated value added accountancy is required that carry the historical cash flow attributes as well as matching principle’s guarantee of recognition of transactions of period under consideration. Standing alone the cash accounting is not a complete accounting system in itself. Accrual accounting has more deliverable attributes than cash accounting. An accounting system is needed to be developed that has the features of cash accounting and of accrual accounting, as well as the power of providing value added information to the users of financial statements. Cash accounting cannot deliver the information that accrual accountancy can provide to the users. Cash accounting is useful basis of accounting but certainly not better than accrual accounting. Hence future belongs to accrual based accountancy with value added features. Word Count of main report: 3297 Part B: Reflective Report Introduction It is simple to implement cash accounting. I have realized that the main virtue of cash accounting is its simplicity. That is why it is popular with those business and professional entities that do not require complete performance assessments. The other major acceptable accounting system is called accrual system. The accrual accounting has special features to evaluate the complete performance of an entity. Still cash accounting has acceptability because of its simplicity and economic advantages. Main report researched these issues with reference to empirical and other literature references with a view to analyze features of cash accounting in comparison with accrual accounting. This reflective report carries a reflective learning experience of research work undertaken in main report. Part 1- An account of theoretical, conceptual, and applied understanding of cash basis and accrual basis of accounting. On practical application of cash accounting, I found that the approach of cash accounting is narrow and conservative. Transactions are recorded only when cash receipts and cash payments occur. Cash basis of accounting does not need any type of accounting adjustments at the end of the accounting period when the performance of the period is measured by preparing an income statement. “Accordingly small services businesses may use the cash basis, because they have few receivable and payables. For example, attorneys, physicians, and real estate agents often use cash basis. For them, cash basis provides financial statements similar to those of the accrual basis. For most large businesses, however, the cash basis will not provide accurate financial statements for user needs.” (Carl S. Warren, James M. Reeve, and Jonathan Duchac, page 103)xv Sometimes I feel that accrual accounting is a complex affair and I will need specialists to implement the system. This is because many new decisions are required to be taken before accrual accounting is introduced. I have also realized that it may not be possible to undertake accrual in each and every sphere of accountancy. “For example, whether a contingency is to be recognized in accounts or whether it is to be recorded off the balance sheet. There is, thus, latitude in deciding the degree of accrual to be used, i.e., in determining the range of assets and liabilities to be included. Also the recognition of revenue can be quite elastic: should it be cash and current financial resources; or does it include non- current financial resources?” (Jack Diamond, page 5)xvi. It is now revealed that even accrual accounting is not a perfect system. Numerous adjustments are required before such a system can be implemented. Moreover, it will cost me a hefty amount if I introduce it in my business. Part 2- Understanding and critical evaluation of cash basis and accrual basis of accounting When I critically analyzed accrual accounting, I found that it covers larger area and presents a better presentation of financial statements than those presented under cash based accounting. I understand that the major limitation of accrual accounting is that expert accounting technicians are required to render complex accrual accounting services. GAAPs insist upon the use of accrual accounting and prepare cash flows statements as part of financial statements. The purpose is to provide analysts an opportunity to reconcile accrual accounting with cash basis accounting. Still the financial statements do not provide complete information to the users of financial statements. Stakeholders and other users of financial statements require certain value added services in order to meet the modern day complexities of decision making. I have understood that value additions to existing accounting system will serve growing demand for quick and ready information to the users. Cash accounting being restrictive in its operation lacks elasticity of additions of value added services. Perhaps this is the reason accounting standards, world over, as well as IFRSs do not recommend cash accounting. “Accounting measures capture past performance and therefore indicate how that historical record has been influenced by, or has gone on to influence, social and environmental performances” (Stefan Schaltegger, Martin Bennett, and Roger Burritt, page 97)xvii But cash accounting does not even captures historical transactions completely. It recognizes transactions that are historical but only associated with cash movement. Whereas, accrual captures the entire historical transactions and recognizes those transactions irrespective of the fact whether those are associated with historical cash flow or future cash flow. Naturally, accrual accounting captures more information and is capable of provided increasing value added information as compared to cash accounting. It is clearly understood that cash accounting is simple and economical but it lacks the ability to enhance its horizons. The learning of accrual accounting reveals that it recognizes the entire happenings during the accounting period. My experience suggests that accrual accounting possesses more data bank than cash accounting. All this make accrual accounting an extensive accounting that provides enough scope to manipulate the recognized information as per objectivity of value additions. I presume that cash accounting is generally used by very small businesses and professionals, where accounting is considered more of a personal affair. It has now been established that “for publically owned companies where the markets reward revenue and profit growth by increasing stock price, many owners prefer and use the accrual accounting because it helps them achieve the abovementioned increases.”(Steven Rogers and Roza Makonnen, page 87)xviii Part 3- Practical analysis as an accountant of cash and accrual basis of accounting An accountant will always appreciate the features of accrual accounting on its practical comparison with cash accounting. What I understand about cash accounting is that it is not meant for those entities that need analysis of complete and entire affairs of the business. Cash is just one of many assets of the business. Accounting for cash is like accounting for only one area of the total business arena. “Accrual accounting method gives the reader of the income statement a richer and more complete depiction of the business’s financial conditions since all revenues generated by the business, and all expenses are stated, regardless of whether actual cash has been received or disbursed.” (Steven Rogers and Roza Makonnen, page 88)xix. My understanding now suggests that cash accounting is inferior to accrual accounting, but its usefulness cannot be denied. Above all, it can be stated that cash accounting is a part of accrual accounting, which is comprehensive and recommended by accounting standards of each country as well as by IFRSs. Word Count of reflective report: 1140 References Read More