The Difference between Full Accrual, Modified Accrual and Cash Budget - Essay Example

Running header: ACCOUNTING Student’s name: Instructor’s name: Subject code: Date of submission: Difference between “full accrual”, “modified accrual” and “cash budget” Full accrual accounting method can simply be said to be the method of tracking only transactions and not cash movement. In other words, the technique actually records all transactions at the point when the action took place and not when the actual transfer of money took place. This implies that when a business performs a service, the income earned is recorded. On the other hand when the business buys an item or a service, the expense is recorded regardless of whether money has actually been received or paid out. Modified accrual accounting technique on the other hand combines both the elements of cash method accounting as well as those of full accrual accounting method. In modified accrual accounting, income earned is primarily recorded just as in full accrual accounting method. However, expenses are only recorded when they are actually paid. This implies that businesses can decide to buy an asset and actually purchase it but the expense relating to that will only be counted and actually reduce the net income in the period in which the check is actually cashed. The technique recognizes expenditure in the period in which the liability is incurred except in the cases listed below; i) Material inventories as well as supplies which are considered outflows when they are bought or when they are consumed. ii) Interest on broad and special evaluation long-term debt which is acknowledged on the due date and iii) Utilization of encumbrances where most of governmental funds utilize the modified accrual method. Cash budget on the other hand recognizes the expected cash inflows and outflows of a business without concerning itself with the matching principle. This means that revenues and expenses can only be recognized as and when there is exchange of cash but not when earned or in the period they benefit. Cash budgets are used in estimating the liquidity of the business. When a business has a good amount of cash in its disposal, it is possible for it to extend credit facilities to customers or incur credit purchases/expenses to be paid in future without getting too much concerned. The major differences between the various accounting systems are explained below; a) Accounts payable – in the cash budget system, a payment is recognized when it is made regardless of whether an expense was incurred in the past or it will be incurred in the future. On the other hand, the full accrual accounting basis recognizes a payable only in the time when the expense was incurred. Similarly but in the absence of any modifications applicable, the modified accrual accounting basis recognizes accounts payable in the period in which the organization/ entity incurs the liability. b) Prepaid assets – while the modified accrual accounting basis may make use of either the purchase method or the consumption method in recording prepaid assets, the full accrual accounting basis strictly makes use of the consumption method where the asset is first capitalized and then expensed in the period it is used or consumed. c) Long-term liabilities’ current portion- the modified accrual method recognizes the liability as it matures or to the extent it is expected to be liquidated with expendable available finances while the full accrual accounting method strictly recognizes the liability in the period in which the organization incurred the liability. d) Long-term liabilities’ noncurrent potion- in modified accrual accounting basis, the portion which fails to meet the criteria for being recognized as a current liability is treated as a non current long-term liability. On the other hand, in full accrual method liability is only acknowledged in the period when the entity incurs the liability. e) Revenues – the cash accounting basis recognize revenue only when cash has been received. Government funds which use the modified accrual basis of accounting recognize revenues when cash is received during or soon after the year end and when it is earned and both measurable and available (in most cases within 60 days). On the other hand, the full accrual accounting basis recognizes revenue in the period in which the revenue was earned and is measurable regardless of whether cash has been received. f) Expenditures – devoid of any applicable modifications, modified accrual accounting basis recognize expenditures in the period they were expended or when they are subject to accrual. Accruals are only recorded when they are expected to use expandable financial resources. The cash basis only recognizes expenditure when cash has been paid out. On the other hand, in full accrual accounting basis, expenses are acknowledged in the period the entity incurs the liability. However, adjustments may be necessary so as to comply with the matching principle is adhered to. (Rabin, 1992) g) Capital asset acquisition- the modified accrual basis recognizes expenditure at the asset acquisition date. On the other hand, the cost of the asset is recognized and depreciated over the expected useful life of the asset in the case of full accrual basis. h) Inventories – the modified accrual basis uses either the purchase or consumption method to recognize inventories while the full accrual basis strictly uses consumption method to recognize the assets when purchased and expenses in the period they are incurred. i) Compensated absences- the modified accrual basis recognize these as liability as payments become due each period when resignations or retirement occur. On the other hand, the full accrual basis recognizes the liability and expense in the period the entity incurred the liability. j) Claims and judgments – these are recognized as liabilities to the level they are usually expected to be settled with expendable monetary resources in the case of modified accrual basis while in full accrual basis, the liability is recognized in the period the entity incurred the liability. B. The issue of transparency Transparency in accounting refers to an economic entity presenting a clear, concise and balanced view of the financial situation to the shareholders. It can also be viewed as a comprehensive concept on the quality of the accounting information. All the relevant information is fully and freely available to the stakeholders and the general public. It includes formulation and implementation of the accounting standards, disclosure of accounting information quality standards as well as the stipulated rules. Transparency may also be defined as the measure of how much information investors have about the market where he or she invest, the stocks and bonds that he is willing to buy, mutual funds or any other investments that he may choose to invest in. The United State’s Securities and Exchange Commission (SEC) requires firms that want to participate in the stock exchange to disclose all the information that is material and is likely to have an impact on the financial statements of a firm and will therefore affect the investors’ decision. (Nicholls, 1991) Transparency in accounting reduces the uncertainties associated with companies in the capital markets. Many companies have been associated with accounting scandals due to inaccurate and incomplete financial statements. Poor performing firms are also know for manipulation of their poor statements in order to attract investors. The Sarbanes- Oxley Act of 2002 established the guidelines of financial reporting. The CEOs and CFOs are accountable for any misleading information in the financial statements of a firm whenever an issue arises. The significance of accounting transparency is that it enables a firm to monitor its business processes and take control of all the material information that could result into restatements. Accounting transparency should include the following three items: a) There must have been a laid down clear, accurate and generally Accepted Accounting Standards disclosure system that economic entities are expected to follow while they disclose their accounting information. Both in the public and the private sector, neither the businesses nor the government is able to strictly follow these rules. b) The analysis of the influencing factors of accounting transparency The standards that are applicable to accounting transparency are quality as well as the quality of the accounting information presented. Quality of information is the core concept in the presentation of transparent accounts. High quality of accounting information is based upon an accounting theory. The more the developed the theory is, the higher the quality of accounting information.( Lynch,1993) c) Factors affecting the quality of information disclosure The quality of the information disclosure system is determined by the corporate governance. This will in other terms be influenced by the board of directors of the company, shareholders structures as well as other aspects of the economic entity based on the legal and cultural practices. The government structures set and information asymmetry between the managers and investors are some of the reasons that threaten information disclosure thus threatening transparency in Accounting. Transparency in accounting will be improved in the following ways: The Accounting research, the assumptions should be improved in order for them to be compatible with the dynamic social-economic environment. Economic entities such as virtual companies should be captured. Operations should be standardized in order to reduce the subjective rules in accounting. Formulation of accounting standards should be scientific in order to maintain stability in them in the future. Education to accountants is crucial too for them to improve their judgment on disclosure requirements. The transparency of the disclosure system technical support should be improved. Companies should ensure a true, information inaccurate, timely and comprehensive disclosure of the issues relating to the economic entity. Corporate governance information disclosure should be incorporated into the legal system and there should be heavy punishment for law breakers. Companies will therefore be discouraged from non disclosure of material information. Only intermediaries with a high quality of CPAs should be allowed to guarantee the quality of the information disclosure as listed by the companies. (Clare, 1994) Lastly, the corporate governance structure should be improved in order to improve transparency in accounting. Companies with very dominating shareholders are likely to have issues of transparency. More spread shareholding increases capital as well as reducing poor management control. There should be specification of the parent company as well as its other controlling shareholders; there should be standardized operations among the companies. C. examples of reporting distortions / discrepancies in using specific accounting tools (i.e. accruals versus cash) Cash and accrual basis are two methods of bookkeeping that differ in the timing of the accounting entries. Firms may choose to adopt any of the two methods of accounting. However, non- governmental organizations with gross profits in excess of $ five million (5000000) must employ the accrual method for purposes of tax reporting. Recording of income The cash accounting method holds that you cannot recognize an income in your book until you have actually received it. For instance, on 1st January 2012, mix LTD sold furniture worth $20000 to X LTD who paid for it a month later. Mix Ltd cannot recognize this income until 29th February 2012 under the cash method. However, in the accrual accounting system, the firm recognizes the sale immediately the order is filled. (Corbett, 1992) This is so even if the buyer has not yet been billed and irrespective of the credit agreement settled on. Revenue therefore cannot be until it’s earned even if cash payment has been received by the tax authorities. Recording of expenses Under the cash accounting system, an expense should only be entered in the books of the firm once the payment is submitted. For instance, Max Ltd incurred purchased stationary from Stationary masters Ltd on 12th February 2012 and payment was due two months later. Max Ltd cannot recognize the expense until the 12th of April 2012 when they actually submit the payment. However, under the accrual accounting method, a firm must enter any business expenses in their books once they are incurred and delivery of the purchased items has been done. If Max Ltd employed accrual basis of accounting, they will recognize the stationary expense on 12th February 2012. Income tax Under the cash accounting system, any unpaid expenses will not appear till the following financial period. They are therefore not deductable in that financial year. Such expenses however will be deductable under the accrual accounting basis as they will have already accrued. The firm can therefore claim that years’ tax return. Revenue cannot be recognized under the accrual method until it’s earned even if a cash payment has already been received by tax authorities. Tax payers for a firm using a cash basis may refer to the doctrine of constructive receipt as well as the doctrine of cash equivalents to help determine when income is received. An accrual basis taxpayer can fall in the category of the cash basis accounting firm when the relevant payment is received by the firm before the required performance and before the payment is actually due. Accounting for inventory Every firm must use the accrual method to account for its inventory. Adoption of the cash basis method would seriously distort the financial statements of a firm. Inventory may be classified into raw materials, work in progress or may be finished good if they are stocked for resale by a manufacture or wholesaler. For instance, if a trader purchased goods on 30th November, he would account for the entire cost then. He would them account for the revenue as he sell the goods with time without accounting for any expenses to match the revenue. Inventories must therefore be accounted for appropriately. (The matching concept)( Levacic, 1989) Accounting for the payroll Employers who adopt the cash method of accounting recognize the cost of the payroll when they issue the cheques or when they pay in cash. The taxes may however fail to be due during the same month thus the firm’s expenses will be incorrectly estimated. Financial statements will also be incorrect if the payroll period spans in a period of more than one month e.g. if a firms pays its workers on every 15th of each month. Firms that choose to accrue should therefore place their labour and tax costs in the month the work was actually done by the employees. The cash accounting methods provides the firm with an accurate cash-flow value at any given time regarding the funds available but in the long run the profitability of the firm may be hard to explain. The accrual basis on the other hand will provide the firm with the accurate statistics of its income and expenditure. Forecasting and budgeting is easier under this method. REFERENCES Clare, R. (1994). Accrual Accounting: fad or necessity? Directions in Government, 8(4), 30-32. Commonwealth Department of Finance. (1994). the new financial reports of agencies. Canberra: AGPS. Corbett, D. (1992). Australian public sector management (Chapter 5). Allen and Unwin. (Dixson 354.9407/C789) Department of Finance (1992). Supplementary financial statements 1991-92. Canberra. Levacic, R. (Ed.). (1989). Financial Management in Education, Open University Press, Milton. (Dixson 379.11/L655f) Lynch, T.D., & Martin, L.L. (1993). Handbook of comparative public budgeting and financial management. New York: Marcel Dekker. (Dixson 336/L987h) Nicholls, D. (1991). Managing State finance: The NSW experience. Sydney: NSW Treasury. (Dixson 336.944 N613M) Rabin, J. (Ed.). (1992). Handbook of public budgeting. New York: Marcel Dekker. (Dixson 350.722/236) Read More