Cash Accounting versus Accrual Accounting - Assignment Example

? TABLE OF CONTENT Chapter Introduction Chapter 2 – Theory ……………………………………………………………………2 Chapter 3 – Practice ………………………………………………………………….10 Chapter 4 – The application of theory to practice …………………………………13 Chapter 5 – Conclusion………………………………………………………………16 References……………………………………………………………………………..17 Cash Accouting V/C Accrual Accounting Chapter 1)Introduction Cash accounting and accrual accounting are the two basic accounting methods used to track the income and expense of a business concern. Precisely speaking, these two methods are only different from each other on the timing they are debited or credited to the business accounts. In cash accounting method, the income is considered when cash is received and expense is considered when cash is paid in real. But in accrual method, transaction is recorded as and when they happen rather than paid or received. So in accrual method the sale or receipt of goods and services are recorded as and when it happens .At times it is not easy to finalize when the sale or buying occurred ,then the contractor confirm the date when he received the goods and services and the transaction is recorded in the books. The cash and accrual method gives the same outcome as one can instantly see the results. The results of these accounting methods will only show variations, if the transaction is on a credit basis. In case the transaction of sales and purchases are done on cash and recorded immediately in the account then, which ever method one use the ledger will reflect the same results. The businesses with sales less than $ 5 million a year can choose whatever accounting method they want for their business. However in both the methods, the result will be only a partial picture of the financial stand of you business concern. Chapter 2) Theoretical View a) Cash accounting method In cash accounting the primary importance is on the inflow and outflow of cash on everyday transaction of the business .As and when money moves in or out, recording is made in the ledger so that analysis can be made to the financial status of the business in a particular accounting period. According to Tatum (2003)“Part of the charm of a cash journal is that financial transactions entered as line items can be reviewed quickly when necessary, as well a providing a quick reference document when entering the transactions into other sections of the accounting books”. The author here emphasize that cash accounting is very reliable when it comes to the informative part of the business activities occurring on a daily basis. Cash is the blood life of a business concern, and cash accounting method allows the recording of the every movement of cash in the firm. The cash accounting method allows a small entrepreneur to understand the profitability of his firm without many complications. But this accounting method is useful mainly for small enterprises .The bigger firms use accrual accounting method where trillions of dollars are transacted at a time and sales and purchase of good and services are time consuming. The cash accounting system is quick and easy and help the owner of business on understanding cash reserves when dealing are mainly on cash basis. For example when one use a credit card to make a purchase, one does not have a reduction in the personal account until one pay for the credit card, this is considered cash accounting b)Accrual accounting If one consider accrual accounting , the revenues and expenses are recorded when they are incurred, regardless of money is moved in or out. As per Duchac (2006,pg.98) “ Accrual accounting concepts are designed to reflect a company’s financial performance during a period and avoid misleading results that could arise from the timing of cash receipts and payments”.The author here wants to reflect on the advantage of accrual accounting to large business firms where huge transactions takes place but money flows in latter period. As per this method cash transaction can be recorded even if it is not received or paid until a certain point of time. Here there is a matching concept to balance the asset and liability section of the financial statement. Generally, most of the businesses use accrual accounting method as they buy and sell products and services on credit basis. For the businesses which have inventory, the accrual accounting method is perfect, especially in sales and purchase activity. However in companies with tax paying obligation, usage of accrual accounting method can be a disadvantage as real receipt and payment of cash may not be recorded. Accrual accounting method can increase the revenue of a business even though the cash is not received thus increasing the tax playability of the firm. Even though the accrual accounting method shows the business transactions more clearly the real cash reserve available in a business form cannot be assessed easily. This is a main disadvantage of accrual accounting method. The advantage and disadvantage of Cash Accounting a) Advantages Cash accounting method is very easy and convenient for people who are not accountant who are using and understanding the records. Cash accounting method is very objective. In this cash either flows in or flows out. In this cash receipts are recorded when they occur and cash payments are recorded when it is made. The small entrepreneurs who use this type of accounting can assess the profitability of their firm very clearly without any complication. The liquidity of the organization is clearly understandable. It is simple way to recording the business transaction and is extremely useful for sole entrepreneurship and small business firms. b) Disadvantages Cost accounting does not allow the understanding of obligation pending or that are due but not yet paid. It does not give a full dimension of what has really happened in the business clearly. Only the inflow and outflow of the cash is projected. When a business has inventory assets involved in it, cash accounting does not allow for proper income tax payment. In this method of accounting, revenue is not matched up with expense and as a result the income statements and balance sheet may not project the real activities in a business firm. The advantage and disadvantage of Accrual Accounting a) Advantages The accrual accounting is very accurate in reflecting the financial position of a business concern. This method of accounting equates the expense with revenue and gives a clear cut financial status of a company. This accounting system enables management of the firm to measure the performance of the company in a right manner as it projects better realistic figures. Accrual accounting is more realistic as it only record the cash received and paid in the business operation .Because of this, it is a safer measurement method for assess profitability and financial status of an organization. Accrual accounting is also perfect when the company need to practice comparison with other financial institutions that use the similar accounting principles. Disadvantages Accrual accounting is more complex than cash accounting method. Under accrual accounting system the company may need to pay tax on revenue not yet received in cash. The accrual accounting system does not match the expenses and revenue at the immediate time they incur. It does not accurately assess the accounting profit of a business concern. It does not take in to consideration the accounts receivable. It does not appropriately project the real cash flow of the business organization. The importance of cash flow accounting in better corporate reporting Cash basis accounting system is an easy to maintain and simple accounting method which can give better insight in to the financial status of an organization .In his book Belkaoui(2004,pg.280)states that “ Many decision usefulness theorists advocate a cash- flow accounting system based on the investor’s desire to predict cash flows”. The author here suggest that theorist believe in cash flow based accounting as it gives wide picture of cash flowing in and out in a business concern. If an investor of business owner needs to get an understanding about the cash reserve or cash flow of his organization , then the cash flow accounting is the best method to be used .A system of cash flow accounting might provide an analytical frame work past, present and future financial performance though a dynamic corporate report. From the point of view of the investors, cash – flow statement project’s both company’s power to pay in the future and the framework of their corporate reports. Moreover cash basis accounting is the most understandable and objective type of accounting system. It allows stating facts in parallel with financial accounting basis, which allows the accountant to make easy judgment on data on its relevant date. The cash flow accounting system also make it easy for non – accountants to understand financial dealing with less complexity. Cash flows and resources are things anyone needs to administer in the today’s developed business arena. Hence the cash flow accounting is highly comprehensible; the corporate reports of the business firms can be transparent and well defined. The role and purpose of corporate reports in business world Every corporate business requires making business reports at the end of an accounting year in order to assess the profitability and the nature of its financial activities. The corporate report is also a form of public disclosure as the investors, shareholders and the public have keen interest in the business activities of a corporate firm. In his book Stanko (2003,pg.54) states that :“A significant component of the corporate annual report is devoted to a presentation of the company’s financial statement, which normally includes a statement of income, statement of cash flow and statement of stock holder’s equity”. A deep analysis is performed with the help of the information provided in these mentioned reports .The importance of these financial statements can be explained as follows: a) Statement of Income : This statement projects the performance of a company in a particular period of time (e.g., one month, one quarter or one year).It is also referred to as profit & loss statement and projects the revenue and expense of a company over a period of time. b) Balance Sheet: This helps in assessing the financial position of a company in a year. Balance sheet shows the list of liabilities and assets of a business firm in a year. In general a balance sheet has three parts; assets, liabilities and owner’s equity. Normally small businesses have simple balance sheet and large corporate have a complex one. c) Statement of cash flows: This statement shows the cash in flow and outflow over a specific period of time. It is a very important financial statement and displays the cash generated during a period of time in an organization. d) Statement of shareholder’s equity: This statement is essential for capital structure decision making. It includes information related to paid- in capital, treasury stock, retained earnings and long term investments. Apart from providing sufficient information about the company the corporate reports also give additional clarification and amplification of the company to the users. Moreover, analysts also use the corporate report to identify the strength and weaknesses of a particular firm. The main aim of corporate report is the function of information sharing and is the foundation on which the important decisions of business are formulated. Corporate report is an important document which helps the investors in updating the information of a company’s operation and financial activity. An investor can also understand the profitability and efficiency of the company with the help of yearly corporate reports. Transparency should be the focus of any corporate report but in current age many financial reports does not give proper and clear message to outsiders. Valuing a company is the main intention of an investor and the main role of management of a company is to provide descriptive information to the users about the company. The investors should understand the short term and long term prospects of a business with the help of a corporate report. Moreover, the corporate reports give an insight about business activities to the owners, government and suppliers. It is nearly impossible for the companies to sustain without the assistance of corporate reports. And also accounting statements gives a fair view of the economic activities of a business concerned whether small or large. The corporate reports are formulated by the professional accountants and are reviewed by the auditors to assess if there is any discrepancy in the financial statements. Chapter 3 Practice The Practice of Cash Accounting Cash accounting is a simple form of accounting useful for individuals and small organization, which do not handle considerable amount of business transactions. It is useful when the time gap between the occurrence of transaction and cash flow is short. Cash flow accounting reflects a proper picture in regard to cash flow, that an owner of the business understands the cash shortage or surplus in the shortest period of time. It has been seen that many business with profitable business have failed due to the problems in the cash flow pattern. In cash flow accounting the depreciation is not recorded as it is taken as a non – monetary expense. The cash accounting does not take in to account the promises and expectations on receipt and payment of money. Few transaction can be explained with the help of below mentioned illustration to understand the cash accounting method 1. Sales / revenue transaction: On January 17th, Green Land Company billed Dreams Ltd. $ 600 for consulting services. Dreams Ltd. paid the invoice on February 6th. Accounting method used: On January 17th no record keeping is necessary as there was no cash flow occurred in to the Green Land Compnay.This company will not record any sale until it will receives the payment from the Dreams Land company. It will be recorded in February and considered as an actual sale. This shows that cash accounting is not appropriate for large organization and huge corporate as they have inventory stock and financial dealings of peculiar nature. 2. Purchase transaction On January 26th Green Land Company purchased $ 126.43 of office supplies from Blackwell stores. The Blackwell stores bills the Green Land Company on the end of the month. Green Land Company makes the payment on February 11th. Accounting method used: On January 26th no record keeping entry is made by Green Land Company as there was no cash transfer from their company to Blackwell stores. Green Land Company will not make a transaction until it makes a payment to the Blackwell stores on February 11th.This transaction will be shown as a February expense. The Practice of Accrual Accounting In the accrual accounting method income is recorded when the actual sale occurs. It generally happens when the shipment of product or service take place in real. Accrual accounting method matches the revenue and income and hence is sharper analytical tool. It requires more complex double entry system of accounting system. Accrual are commonly performed to make adjustments prior to the accounts are in final astage.Prior to the final accounts are finished, it is important to make needed adjustments in the trial balances of an organisation.One of the fundamental principle of accrual accounting is that revenues and costs should be recorded when they are earned and not when the cash is received. In her book Pinson(2007,pg.12)writes that : “ In the accrual accounting system the recognition of revenues and expenses at the time they are earned or incurred are considered , regardless of when the cash for transaction is received or paid out “. Little transaction can be explained with the help of illustration to understand the Accrual accounting method 1. Sales / revenue transaction On January 17th, Green Land Company billed Dreams Ltd. $ 600 for consulting services. Dreams Ltd . paid the invoice on February 6th . Accounting method used On January 17th sale is recorded by the Green land Company despite of the absence of cash transaction from the part of Dreams Ltd Company. Green Land Company can be considered as earned the income on January 17th, even though it will not have cash receipt until February 6th.In other words it is regarded as a January sale of the company. So here it is not the receipt or payment of cash is given importance but the earning of it is recorded in the ledger. This kind of accounting keeps a track on the date where transactions have occurred and make entering in the books of records. 2. Purchase transaction On January 26th Green Land Company purchased $ 126.43 of office supplies from Blackwell stores. The Blackwell stores bills the Green Land Company on the end of the month. Green Land Company makes the payment on February 11th. Accounting method used: On January 26th the expense is recorded by the Green land Company even though it did not make any cash payment with the Blackwell Stores. Green Land Company is considered to have incurred this expense when it purchased the office supplies from Blackwell stores. The cash payment will not be made until February 11th and transaction will be shown as a January expense. Chapter 4 : The application of theory to practice Cash basis accounting and accrual accounting Cash is the foundation of any business concern and is an accurate measurement for the financial solidarity of a firm. The cash represents the amount of resources available to meet the contingencies and needs of a business organization. Moreover, the actual measurement of cash inflows and outflow is only possible with the aid of cash flow statement. For the investors, management and creditors the cash flow projection is an important activity. The primary objective of a cash flow statement is the projection of cash inflow and outflow during a specific period. A small business makes use of cash flow statement and records transaction on a daily basis. It is simpler than accrual accounting and allows the use of single entry system For example Orchid Interiors have revenue of 5,300 for January. In that 3,230 is from cash sales and 2300 is from invoice to clients who is not yet been received. In the same month expense of $ 3800 has been incurred for the period - $ 3000 has been already paid and $ 800 is still due. In this example, according to cash accounting method revenue and expenses are realized in the period in which the firm receives the actual cash or pay the actual bill .In this case only $ 3230 of revenue and $ 3000 of expense are recognized for the month. Since rest of the expenses and payment are due they are not considered in the recording of transaction. Only actual cash inflow and outflow is regarded and this will give a clear picture of the cash reserve. In accrual accounting the revenue and expenses are taken in to consideration as and when they occur and are recorded in the books. This accounting system does not regard whether the revenue has been really collected or expense have been really made in terms of cash .This means that revenue and expense are realized in the same year it has occurred. Here the matching principle is practiced where expense is matched with revenue by means of double entry method. According to Davidson(2009)“The accrual method must be used to match revenues and expenses of financial statements prepared in accordance with Generally Accepted Accounting Principles (GAAP). However, most small businesses can choose whichever method suits their business (and record keeping!) needs best”. In preceding example we can see the business is incurring paid and unpaid revenue and sales. According to the accrual method there $1500 is the gross profit for the month. In this case the profit is “ paper profit”since $ 2000 not yet received in cash. This accounting needs double entry in the books as revenue and expense has to be matched. A comparison of the cash and accrual accounting method can be shows as below: Accrual Method Cash Method Revenue $5300 $3230 Expenses -$3800 -$3000 -------- -------- Gross Income $1500 $230 -------- ------- The accounting procedure of a business has a significant effect on the total revenue of the corporate report and on the expense of the business. In cash flow system the expenses and incomes are practically matched on a monthly basis. In this method the liability is not recorded unless the payment is made to the other party. The financial statement outcome of both cash accounting and accrual accounting can differ due to the time period difference in both accounting method. In cash accounting ,single entry system is practiced where is in accrual accounting double entry is used in record keeping. Most of the accounting record keeping is based on double – entry book keeping. The single entry book keeping can be compared to the check book register where each transaction is registered in one column with an amount written across it in another column. While double entry system that is accrual accounting persists that every transaction is recorded twice in the books of accounts. In double entry system the cash account is credited if cash is paid for a debt and creditors account is debited. Using double entry is the standard accounting method used by most of the business organization where there is inventory stock, accounts payable and receivable .Here the total of all debit balance equal with the total of all credit balances. The double entry account types can be explained as asset accounts, liability accounts, income accounts and expense accounts. Nowadays, all the accounting system is performed with the help of accounting software and hence the work load of accountants is lightened to a great level. Conclusion In general we can understand that all business enterprise need some type the accounting method in order to run their day to day business operation. Cash accounting method or accrual accounting method is the corner stone of a business enterprise. When cash accounting displays the actual cash a business possess, it misleads about the profitability factor on a long term basis. Choosing a proper accounting method is very crucial for a business enterprise. If not properly selected the accounting method can be a worse problem for a business enterpreneur.This is because an inappropriate accounting method can cause a business unwanted expense and wastage of time and energy, if encountered with unnecessary errors. Also choosing a right method of accounting system plays a big hand in the tax payment method of a business concern. Legally, the method of accounting used by most of the business firm and professionals is the accrual accounting method. One main factor for this is that, in case of cash accounting method there is no mention of receivable or payables in the balance sheet. Receivable and payables can also be the accrued income or expenses which are ignored by cash accounting method. So big corporates and business organization accept accrual method of accounting as it delivers a precise and accurate financial report and statements. Also GAAP and IAS accept accrual accounting method as the standard accounting principle to be used by corporations and partnership firms. Bibliography Belkaoui, A.R., 2004. Accounting theory. 5th ed. London: Cengage Learning Duchac, J.E.2006. Financial accounting: an integrated statements approach . 1st ed. Mason: Cengage Learning Davidson,L.. 2009. Accrual Accounting for Non- Accountants. [ONLINE] Available at: http://www.businesspundit.com/accrual-accounting-for-non-accountants/. [Accessed 27 May 11 Pinson, L., 2007. Keeping the Books: Basic Recordkeeping and Accounting for the Successful small businesses. 5th ed. Chicago: Kaplan publishing. Stanko, B., 2003. Understanding corporate annual reports: a user's guide. 1st ed. New Jersey: John Wiley and Sons Inc Tatum,M.. 2003. What is a Cash Journal?. [ONLINE] Available at: http://www.wisege ek.com/what-is-a-cash-journal.htm. [Accessed 27 May 11]. Read More