A Difference in Recognizing Transactions - Essay Example

Cash Vs accrual Is there a difference in recognizing transactions?  Cash Vs accrual In United s, the taxable income is calculated based on two primary accounting methods; cash basis method and accrual basis method. According to the Internal Revenue Code (The main body of domestic statutory tax law of the United States), taxable income can be calculated by the taxpayer with respect to the cash receipts and disbursements method, accrual method, combination of any two methods or any other methods permitted by the Internal Revenue Code (IRC). The core principle behind the income calculation is that the taxpayer must use same and consistent accounting method for the calculation of taxable income and in the book keeping process. Whenever a taxpayer intend to change his accounting method, he/she should take prior permission from the concerning body. There are major differences in recognizing the transactions while the income is calculated on the basis of cash and accrual. This paper analyses the cash and accrual methods of accounting and identifies the differences in transactions between them. The differences in transactions: Cash Vs accrual Cash basis accounting is easy to understand. In this type of accounting everything is based on the cash received and the cash paid. For example, consider a sales person sells a DVD player and collects the cash for it. He will record his payouts based on the item sold and the cash received on the same day itself. In other words, cash accounting method can be used effectively when an item is sold on the basis of cash on delivery. But this method may create practical difficulties when a transaction occurs on the credit basis. In most of the current sales deals, the seller may get the actual cash from the buyer only after some days from the actual selling date. If the seller uses the cash method of accounting he can record his sales only after he receives the payment even though the invoice was issued at an early date. This method of accounting is impractical over a period when a company acquires more sales and more customers because of the difficulties in tracking the payment. On the other hand, in accrual method of accounting, the above difficulties can be solved up to certain extent. Accrual system records transactions as they take place. When you invoice a customer or make a cash sale then the transaction is recorded. And of course when you receive a bill you record this transaction as well. It does not matter that the bill hasn’t been paid yet. Later when your invoice is paid or you pay a bill to your vendor then that payment will be recorded. With this system you also can record partial payments. And you have the ability to better track how many projects your business completed over a certain period of time (Miller, 2008). Cash received and cash paid are the major entities in the cash method of accounting whereas in accrual method, item earned and expenses incurred are the major entities. In other words, the tax payers include the income when it is received and they claim the deductions only when the expenses are paid in cash method of income calculation whereas in accrual method taxpayers include items when they are earned and claim deductions when expenses are incurred. Suppose company A delivers 1 million T-shirts to company B on a credit basis and this delivery was happened in the penultimate month of the current financial year. If the payment terms are within three months from the date of delivery, Company B wants to pay Company A in the next financial year only. IF accrual method of accounting is used, Company A will take this deal as the revenue earned in the current financial year itself even though they are going to get the actual payment in the next financial year. Company A’s income statement for the current year will include the above deal also if even though they are going to get the actual payment in the next financial year. On the other hand if Company A is using the cash method of accounting, they will never include this deal in the income statement while submitting their income statement for the current year. In other words, in cash method of accounting the income may not be recorded until the cash is received. Even though the accrual method is more practical than the cash method, at times it can cause problems both to the sellers and the buyers. Income and debts may not be reflected accurately while using accrual method of accounting. In other words, it is difficult to evaluate the present status of a business easily while using this method of accounting. For example, the income ledger may show millions of dollar in sales when the actual bank balance was empty when using accrual method. On the other hand, cash method of accounting is simple and can reveal the present conditions of the company or the individual entrepreneur easily. Whatever revenue obtained from the sales made will be there in the bank while using cash method. Though the cash method provides a more accurate picture of how much actual cash your business has, it may offer a misleading picture of longer-term profitability. Under the cash method, for instance, your books may show one month to be spectacularly profitable, when actually sales have been slow and, by coincidence, a lot of credit customers paid their bills in that month (Cash vs. Accrual Accounting, n. d). It is difficult to analyse the present business climate accurately if a company uses cash method of accounting. For example, suppose a company got some big orders in the last month and the buyers paid them in this month. Even if the actual sales of this month were less than the average, because of the outstanding payments received in this month, the accounting book may show excellent sales in this month. A person, who analyses the business climate with the help of these accounting books, may forecast the business opportunities wrongly. Conclusions Both cash and accrual method of accounting have its own advantages and disadvantages. Cash method is simple and easy to understand whereas accrual method it bit complex and difficult to understand. Accrual method is suited to the big businesses whereas the cash method is suited to small businesses. Accrual method helps the accounting people to analyse the business climate more accurately whereas the cash method can provide misleading data about the current business climate. References 1. Cash vs. Accrual Accounting (n. d). Nolo. Retrieved from http://www.nolo.com/legal-encyclopedia/article-29513.html 2. Miller, C.J. (2008). Accounting Basics: Cash vs. Accrual. Retrieved from http://www.suite101.com/content/accounting-basics-cash-vs-accrual-a75768 Read More