Cash Accounting vs Accrual Accounting - Literature review Example

Cash Accounting Vs Accrual Accounting Name Tutor Course Institution Date List of Contents List of Contents 2 Cash Accounting Vs Accrual Accounting 3 CHAPTER 1: Introduction or Theoretical Background 3 Introduction 3 CHAPTER 2: Theory from Literature 4 Accrual Accounting 7 CHAPTER 3: Practice from literature 10 Cash Accounting versus Accrual Accounting 10 CHAPTER 4: The Application of theory to practice 15 The Role and Purpose of Corporate Reports 15 Example 15 CHAPTER 5: Conclusions and Future Recommendations 17 Conclusion 17 List of Tables and Flow Charts Cash Basis Accounting Flowchart………………………………………………………….…….5 Accounts Payable Flowchart……………………………………………………………….…….8 Table 1: Transaction indicating the Accounting method………………………………………..11 Table 2…………………………………………………………………………….......................12 Table 3……………………………………………………………………………………….…..13 Table 4: The difference between Cash basis and Accrual Accounting…………………………13 Cash Accounting Vs Accrual Accounting CHAPTER 1: Introduction or Theoretical Background Introduction Financial and accounting records of any business play an integral part in the success of the business. Thus it is essential to comprehend critical principle techniques that are engaged to keep trail of the business revenue and outflow. The major methods are the cash and accrual methods of accounting techniques. According to Markle, (2004) the suitability of each accounting techniques will vary from one business or company to the other depending on the magnitude of the business and the timing of the transactions the business is involved in. Accrual accounting method involves the counting of income whenever a cash sale arises and expenses tabulated after the reception of goods and services. Thus the major consideration is the date of the conclusion of the job; the transaction is recorded after the service or goods are delivered. Transactions are recorded when they happen as opposed to when the payment is actually done. In cash technique of accounting revenue is recorded when the cash is acknowledged and expenses recorded whenever they are being remunerated. It is often argued that the cash accounting technique is usually applicable in smaller business where simple transactions are carried out on cash basis (Markle, 2004). Accrual basis accounting is applicable in complex business situations as it provides more financial information in regards to the progress of the business. Hence the main difference between the cash and accrual methods of accounting is the instance within which sales and purchases are either credited or debited in their respective accounts. The paper will therefore seek to critically explain cash accounting and accrual accounting as techniques used in accounting and their purpose in financial accounting in United Kingdom. It will also seek to bring out the differences between cash and accrual methods of accounting based on the reported financial results of a company (Pratt, 2003). CHAPTER 2: Theory from Literature Cash Accounting According to Tracy (2011) cash accounting is also known as a straight forward approach in financial accounting. This is a system whereby transactions are recorded the moment they occur in the business. Thus the timing of the transaction states when the journal opening is prepared in the financial record. This type of accounting technique does not correspond to the occurrences that are not components of business operation or exchange for instance resources and liabilities that are being accrued or expiring over a given period of time; for instance bank interest earned over time and depreciation of assets over a period of time. Due to nature of its transaction this technique is mainly used for simple financial situations such as personal financial record keeping and other small business enterprises. An example of a cash accounting method is when a business engages in a computer installation business in January but does not pay for it until three months later in March. Under the cash method the payment will be recorded in March when the actual payment for the computer installation is done (Tracy, 2011). Cash accounting is regarded as the most suitable method since it offers a clear picture of the actual available cash in the accounting books for respective a month that is used to gauge the profitability of any business endeavor. However it can also be misleading in the sense that it does not supply the business with a clear picture of the progress of profitability on a long term basis. With cash accounting the business entity will be in a position to know its cash flow at hand and therefore make appropriate short term decisions in regards to the company. However, the main disadvantage of the cash basis accounting is that there is limited financial information that can be retrieved over a long period of time. This will therefore limit the business in terms of making long term decisions concerning their financial situation. Cash accounting techniques are more appropriate with small business owners who are seeking to manage their tax bill (Warren et.al. 2010). In cash basis accounting expenses are recorded by check entries. The flowchart below displays the details of the cash basis payment procedure; Cash Basis Accounting Flowchart According to Taylor (2003), in regards to ordinary VAT accounting, VAT is paid on sales irrespective of payment or non payment of the customer. Thus with the use of cash accounting VAT is remitted when the customer has actually made the payment. With the application of cash accounting scheme VAT is paid on sales whenever the customer pays and VAT on purchases reclaimed when suppliers have been paid. Cash accounting method can only be applicable in a business whereby the estimated VAT taxable turnover does not exceed £ 87.75 million. The benefits of cash accounting scheme in VAT is that it helps enhance the business cash flow among the slow paying customers. This is because the VAT is paid when payments have been received from customers. If the customer fails to make the payment VAT is not paid on the debt as long as the business continues to apply the cash accounting scheme (Taylor, 2003). In the application of cash basis accounting, companies and businesses record expenses in financial accounts when the cash is actually paid out and book revenue whenever they occur. This method of accounting is most appropriate for small business and makes bookkeeping and basic accounts arithmetic simple (Warren, 2012). An example of a cash accounting transaction is when a company installs and computer and completes it after one month. Cash accounting transaction occurs when the company is actually paid upon the completion of the computer installation. If the installation was done in the month of May and completed during the same month then cash accounting occurs if the company is paid in the month of May. The same situation is also replicated if a company makes and expenditure. Upon the payment of the expense made it will be recorded as a cash accounting technique (Saracino, 2007). Accrual Accounting This technique involves two major important principles in its application. It recognizes any business transaction and occasionally adjusts the financial statements so as to enable the net income to match with the specific time. Thus accrual accounting identifies business dealings when the economic occurrence has taken place as opposed to when cash is received. Diamond (2002), argues that the transactions are further categorized as resources, liabilities, equity, incomes or expenditures. The main objective of accrual accounting enables financial statements to be recorded as they arise. In the long run trends in expenditures and revenues are replicated in the fundamental economic significances of functional resolutions within a given period of time. The accrual foundation affords companies with information on matters such as assets, the cost of operation among other beneficial information that facilitates the company to evaluate its economic situation and any alterations within a period of time. It also assists the company to gauge whether it is functioning resourcefully or economically (Diamond, 2002). It is argued that the accrual method of accounting is the best suited for any kind of business since most business do not transact on a cash basis most of the time. Hence the accrual method provides a more accurate picture of the business in terms of the business income and debts. On the other hand it does not present a clear picture of the available cash reserve (Shaffer, 2010). An example of an accrual transaction is when a business purchases a computer in June but pays for the same in September. In the accrual basis of accounting the transaction will be recorded in June while waiting for the payment in August. Accrual accounting records expenses incurred even when the suppliers have not been paid yet. According to Generally Accepted Accounting Principles incorporated companies should use accrual technique of accounting since the technique used has a great impact to the financial situation of the business. The application of accrual technique of accounting is only limited to a company that is a conglomerate, has an inventory and its revenues is greater than £ 3.25 million (Khan & Mayes 2009). In accrual basis accounting expenses are recorded by use of accounts payable through the entry of bills and the issuance of checks in the payment of bills. The accounts outstanding flowchart demonstrates the movement of transactions in an accounts payable structure. Accounts Payable Flowchart Accrual basis accounting is therefore a system of accounting that is founded on the accrual principal. Revenues are recognized when earned and expenses whenever they are incurred. Due to the accrual basis principles of accounting the business entity will be able to access more detailed financial information that in the long run will enable the business to ascertain whether it is making profits or losses and make necessary adjustments as the financial information at that particular period (Larkin & Ditommaso 2010). An example of accrued revenue Example: A company sold its products at £ 6,500 in the month of May 2011 and cash was received in the month of June 2011. May 2011 June 2011 Revenue recognized Cash is received A journal entry in the month of May will be as follows; Debit Credit Accounts receivable £ 6,500 Sales £ 6,500 A journal entry in June 2011 will be as follows; Debit Credit Cash £ 6,500 Accounts receivable £ 6,500 An example of an accrued expense Example: A company borrowed £ 500,000 in September 2011 with an interest rate of 12% at the end of each quarter. September October Interest expense is recognized for September Cash payment is made at the end of the quarter A journal entry can be made as follows; Debit Credit Cash £ 500,000 Borrowings from bank £500,000 CHAPTER 3: Practice from literature Cash Accounting versus Accrual Accounting When initiating any business it is important to be ware of which accounting techniques to use in the recording of the business transactions. Thus the business has to choose between the cash accounting method and the accrual method. The choice of which accounting technique to apply to a business will be dependent on several factors. These factors may vary from the size of the business entity to the types of transactions the business is likely to receive. The main difference between cash accounting technique and an accrual technique lies in the timing of the recording of the transaction made (Jefferson et.al 2011). Whereas in cash accounting method a transaction is recorded whenever cash is exchanged or income recorded when there is cash payment and expenses documentation when expenditure is paid in cash or credit card. In regards to the accrual technique of accounting the documentation is done when a transaction occurs as opposed to when cash is received by the company. If the company extend credit to its customers and permits them to purchase items on credit to pay at a later date; the business incurs accounts receivable (Thus accrual accounting Porter & Norton 2012). In today’s changing world not all business functions on a wholesome cash accounting method due to the fact that products are often sold and payment made at a later date. Thus the application of an accrual method of accounting provides a clear picture of income and expenditure; profitability. Accrual accounting technique also requires the application of a double entry book keeping as opposed to the cash accounting method. On the other hand cash accounting will enable a company to be aware of its cash flow as opposed to the accrual method of accounting (Warren et.al. 2010). If a company earns income in May but the payment is not made until July, in cash accounting method the transaction will be recorded in July whereas in accrual accounting method the transaction will be recorded in May when the transaction occurred. It can be illustrated as follows; Table 1: Transaction indicating the Accounting method Transaction Month of Transaction Month payment was made Accounting Technique Purchase of a computer May May Cash Income earned May July Accrual The cash basis accounting does not take into account accrual of income and expenditure but only identifies revenue when payment is acknowledged and expenses when payment is completed. Cash accounting does not allow matching for revenues against expenses within a predetermined accounting period thus comparisons of the previous periods cannot be undertaken as opposed to accrual method of accounting that allows for comparison between different financial periods (Epstein, 2010). A great difference is also evident in the way a company records payment of payroll taxes in the company that uses cash accounting technique and the accrual accounting technique. In accrual accounting, every moth the company puts aside the sum total it anticipates to remit towards its quarterly tax bills for its staff by us of accrual. This is a paper transaction whereby money does not exchange hands. The transaction is entered into a tax liability account that is used for trailing tax payments that have been completed that those that are yet to be completed. Whereas in cash accounting liabilities are not recorded until the payments are actually done to the government. The company incurs tax expense each month and manifests a higher profit during the first two months of the quarter and loss in the other half (Ingram & Albright L 2006). Another major difference between the cash accounting system and the accrual method is that single entry is used in cash accounting whereas double entry is mainly applicable in accrual accounting technique. This enables accrual adjustments to be made spontaneously. Double entry system in accrual accounting also offers entrance to existing and comprehensive fiscal data during the year so as to track monetary presentation and make any necessary financial evaluation of the company. Accrued revenue is income that has been made but not received. Thus income has to be documented in the accounting time that it was made (Bassessur, 2008). Accrued income has to be identified in the accounting epoch that it arose rather than the period that was acknowledged. Hence as income is being credited to document accrued revenue, a conforming receivable will be prepared to account for the debit side of the business deal. The accounting record to document accumulated revenue is shown below; Table 2 Debit Revenue Receivable (Balance Sheet) Credit Income (Income Statement) Example Scott Company LTD obtained interest of £ 20,000 on a bank deposit for the month of December 2011 on 10th January 2012. The company has an accounting year ending 31st December of every year. Thus the company will identify interest income of £ 20,000 in the financial statements of 2011 even though it was received in the next accounting period. The double entry system will be used to record the transaction as shown below; Table 3 £ £ Debit Interest Income Receivable 20,000 Credit Interest on Bank Deposit 20,000 Accrual basis accounting relates revenue to the period that they are received and corresponds expenses to the period that they were experienced. Accrual accounting is more multifaceted than the cash basis accounting as it offers more detailed information about the status of the company/business. The accrual basis permits tracking of receivables and payables. Thus accrual basis gives room for matching revenues with expenditure sustained in the process of earning them; presenting further meaningful financial reports (Porter & Norton 2012). The difference between the cash basis accounting and the accrual basis can be tabled as follows; Table 4: The difference between Cash basis and Accrual Accounting Cash Basis Accrual Basis Income is documented upon receivable; it can be earlier or after being earned. Income/revenues are recorded upon being earned; may be before or subsequently being acknowledged Expenses are documented upon payment; previously or after being incurred Expenses are documented upon being incurred; before or after payment is made. Financial statements relate with revenues and expenditure on the basis of entry of transaction relatively than while revenues were received or expenses experienced. Financial statements corresponds revenues to the expenses sustained in earning and further precisely reflect the outcomes of the operation. Receivables are not recorded Receivables are documented but payment is not acknowledged at the point of transaction. Payables are not recorded Payables are recorded although reimbursement is not completed at the point of purchase Technique of tracking incomplete payment non existing There is complete recording of revenues and expenditure but payments are extended over a period of time. CHAPTER 4: The Application of theory to practice The Role and Purpose of Corporate Reports Corporate information is financial reports that are documented so as to track the financial performance of a given company. Corporate reports does not only cover the financial aspect of the business entity but also the legal system that governs the different structures within the business. Hence it is important to note that corporate reports plays a major role in regards to the success of the business and how it will be run and managed. This is usually done to ascertain whether the company is making profits or losses (Diamond, 2006). Thus the main purpose of a financial report is to provide financial information to investors and lenders of the company. Financial reporting forms an important foundation of a contract between the business and the shareholders. This is important due to the fact that the shareholders need to be aware whether the business is making profit or not. A financial report is essential since it aids in answering certain key financial question; if the business is making profits or not, how much assets and liabilities the company has, where the company acquires its capital and if the company reinvest all its profits or not. Financial reports are usually compiled after auditing of the company is done and an auditing report done. Auditing of the company can be conducted by an internal or external auditor whichever the company feels it is appropriate (Tracy, 2009). Example After an auditing report was done and a financial report compiled, ABC company realized that its revenue was £ 1,000,000 and its expenditure £ 800,000. This can be explained in the financial report that the company was making profits. However when company ABC revenue is £ 800,000 and the total expenditure £ 1,000,000 it implies that the company was running at a loss. Whenever the business is running at a loss it means that something has to be done to avert the situation. It is only through the corporate reports that weaknesses will be pointed out for the necessary interventions to be implemented. This is due to the fact that the financial information will single out the weaknesses form their financial reports. According to Lee (2006), most companies conduct their audit yearly so as to gauge if the company is making profits or not. When the financial report of a company indicates that the expenditure is more than the income/revenues then the company is running at a loss. However when the revenues of a company exceed the expenses incurred by the company then profits is realized. In any business entity corporate reports play a very crucial role in regarded to the sustainability of the company/business. Without such reports a business will not be in a position to gauge whether it is making profits or losses. Thus a company should invest in these reports as they usually point out the weaknesses and strengths of the company. In this regard they help the company to seek out any necessary interventions whenever they realize that they are incurring losses instead of making profits. Hence these reports serve as guidelines for the company in terms of their sustainability and growth (Lee, 2006). According to Porter & Norton (2012) the superiority of recounted financial material is not only predisposed by the quality of accounting ideals but rather by underlying institutional features such as corporate authority, the legal structure among other factors. Thus the quality of financial information acknowledged by users is a product of both the excellence of accounting principles prevailing the revelation of accounting information together with the supervisory application or corporate presentation of the values in an economy. The United Kingdom is a corporate law country although her affiliation in the European Union subjects her to important code regulation infiltrations. Hence grounding financial reporting procedures on the legal structure variation is progressively less sustainable. Financial statements play a crucial role in providing a company’s financial information. For instance an investor who wishes to invest in a particular company will be required to know the worth of the company that they wish to make investments. Thus the financial statements of a company will put into perspective the sources of the company’s revenue and its total expenditure. This will encompass what the company owns and what it owes others. The financial information will also be useful in determining how much profit the company makes and the financial situation of the company at a particular period (Porter & Norton 2012). Heintz & Parry (2010) argue that most companies formulate balance sheets as a way of briefing their financial situations at a given period of time; this statistics fluctuate over time. Thus a balance sheet acts as a summary of the company’s resources, obligations and parity at a given period of time. The balance sheets also act as guide to the company in terms of their assets and liabilities. Thus the company will be in a position to know the value of their assets and liabilities. Through the use of this information the company will be able to know if it is making profits or not and identify the weaknesses in their operation. The process of auditing the financial reports of companies begins with the methods of accounting the company uses. Thus the cash and accrual methods of accounting form the major foundation in any financial reports of a company (Heintz & Parry 2010). CHAPTER 5: Conclusions and Future Recommendations Conclusion Selecting a record-keeping procedure is a vital decision for any business entity to make. The choice of the accounting method to apply will greatly aid the business with the decision making in regards to a risky environment. Thus in financial accounting there are two major methods of accounting that a company can apply. The cash accounting technique and the accrual accounting system differ in their mode of application and the suitability of each method depends with the nature of the business and the size of the business. The accrual method of accounting is most appropriate with a complex type of business. It is also the most appropriate method of accounting since it gives a clearer picture of the situation of the business and more detailed financial information in regards to the business. A cash accounting technique is most suitable for simple businesses that mostly engage in cash transactions. Accrual accounting method is preferred by most businesses since it provides a clear picture of the existing assets and liabilities within the company. Financial information of any company or business plays a very crucial role. This is because a financial report acts as a form of gauging whether the business is making profits or losses. In situations where the business is running at a loss the financial reports help in pointing out the factors leading to the loss making of such business. Cash accounting and accrual accounting act as a foundation in any financial reports. Thus it is the role of any company/business to ensure that the choice of the accounting method meets the needs of the company in regards to the provision of the financial information to the business. The main aim of operating a business is to earn profits and make the business sustainable. This can only be achieved through the choice of a suitable accounting method that will in turn provide essential financial report. Hence the choice of the accounting method to be applied to any business/company will highly depend on the type of financial information the company wishes to obtain in the long run and the usefulness of the financial information to the business entity. Financial information acts as a key element in any business and thus more resources should be channeled towards ensuring that a company obtains appropriate financial information at a given period of time without jeopardizing the company as a whole. Thus both cash and accrual accounting act as a cruel aspect of the financial information for any company. It is through the accounting methods that financial reports are formulated through the process of auditing. List of References Markle, K 2004, August).Introduction to Accounting. 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