Accruals vs. Cash Basis

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Introduction

Accounting is the process of providing quantitative and qualitative information about economic agents or entities. This is meant to help users in making decisions concerning the allocation of economic resources. Accounting discipline has missions in its operation; this includes the facilitation of value creation. Value creation mission is achieved by supporting resource acquisition and allocation decision making. Value can be realized to economic wealth if one refers only to shareholders. This is because; shareholders only look for financial return on their investment. The second mission for Accounting is to measure and report to stakeholders the amount of value created during a given period.

Accounting environment is dominated mainly by two forms of Accounting. These are managerial and financial accounting.  Although Accounting is a complex discipline, the duality mission has led to separating into two closely intertwined subclasses (Kolitz 2009). This is based on the different users who have access to its output. Managerial Accounting deals with a rather detailed account of how resources are acquired managed and used in the various business processes of a firm.  Financial Accounting is aimed at reporting in somewhat aggregated way the economic performance of the firm to external users. These users may include shareholders, brokers, creditors, customers and tax authorities. The purpose of this essay is to discuss both cash and the accrual basis of accounting and making a comparison of the two.

Financial accounting focuses on the financial or monetary aspect of performance because of its output the general purpose financial statements (Rich 2013).  Accounting information is a social good and regulated so that all classes of users receive signals of equivalent significance. Financial Accounting information system is the process of prescription of various events that take place in the life of a firm. These events are essentially transactions both the firm and outside parties. The description of each elemental transaction is materialized by source documents that contain both financial and non financial elements to allow for evaluation of that transaction. Transactions are recorded, classified and analyzed so as to allow for periodic creation of synthetic reports called financial statements.

Objectives of financial reporting and accounting are to provide useful information to current and prospective investors and creditors (Kimmel 2011). This is to facilitate in decision making for investments and also credit granting. The information must be comprehensible by those who have reasonable knowledge of business and economics and are willing to study the reports. Financial information is useful if it allows the decision makers to predict the amount, timing and uncertainty of future cash flows (Warren 2013). Accountants who prepare financial statements should ensure that the information used is accurate and timely. It should also incorporate the past events for a clear comparison of the trend.

There are many principles and conventions that govern the discipline of accounting. Regulators set them because accounting is the language of business communication between those who prepares the financial statements and the users (Godwin 2012). The language is common all over the world because of harmonization by the principles and conventions. This facilitates comparison of two firms in the same industry but in different locations of the globe. These doctrines and procedures are known all over the world as the Generally Accepted Accounting Principles. They guide the accountants in their performance of duties of preparing financial statements (Gibson 2012). Accounting principles are the guides or beliefs that are held by practitioners of the Accounting discipline and they act as a compass.

Accounting principles are categorized into two classes; Accounting concepts and Accounting conventions. Accounting concepts are the fundamentals of accounting discipline. They are assumptions which accountants use to base the accounting discipline. The following is some of the commonly used concepts:

  • Business entity concept- this concept states that a business should have a distinct life from that of its owner. The concept is based on the accounting equation of Assets = Liabilities + Capital. Owners of businesses whether sole proprietorship or partnerships should record all the transactions happening in the firm (Godwin 2012). This will facilitate the preparation of accurate and reliable financial statements.
  • Money measurement concept- the concept is based on the fact that money is a standard of measure for all the transactions in a business. Accountants record all the transactions taking place in a business in monetary terms (Gibson 2012). This facilitates the comparison of different entities in the industry.
  • Going concern concept- the concept states that a business is a going concern and not a gone concern. It is based on the notion that a business will continue in operation and making a profit in the indefinite future and does not intend to close down. This concept explains the reason why all transactions in a business entity are recorded in the bookkeeping (Warren 2013). This justify why non-current assets are recorded at their historical cost and depreciated with the passage of time. Non-current assets are not meant for resale and thus they should not be recorded in their net realisable value when reporting the status of a business entity.
  • Cost concept- this concept is related to the going concern concept of accounting. It states that an asset should be recorded in the books of account at cost or the price that was paid to acquire it. The cost will be the basis for future accounting for the asset less the depreciation that will have accumulated.
  • Dual aspect concept- the concept is the basis of the accounting equation. It states that, for every debit there must be a corresponding credit entry. This concept is commonly referred to as the double entry rule of accounting (Godwin 2012).
  • Accounting period concept- this concept is based on the going concern concept where a business, which is not intending to close down in the foreseeable future, should divide the useful life into periods. These periods will be the basis of accounting and especially in the determination of profit or loss of a business.
  • Matching concept- this concept is based on the accounting period concept. It states that, all the revenues recognised in a period should be matched with all costs incurred in that period for profit or loss to be determined (Kolitz 2009).
  • Realisation concept- the concept states that revenue should be recognised when an asset changes ownership to the buyer.
  • Objective evidence concept- the concept is based on the rule of trustworthiness. Financial data used in preparation of financial statements should be accurate and from reliable sources so as to build the confidence of the users of this information.
  •  Accrual concept- this concept has its foundation in the realisation concept. It states that a transaction’s effect should be recorded once it occurs and not when cash is paid (Kolitz 2009). Similarly, an expense should be recorded in the period it was incurred regardless of whether cash was paid or not. In the preparation of financial statements, all the outstanding expenses and incomes should be included for a true and fair value of a business entity to be reported.

The following are the accounting conventions commonly used and also relevant to the discussion of this paper:

  • Consistency- the convention states that, all the accounting procedures and practices should be adhered to all the time. There should be no change of the practice from one year to another. This is based on the rule of comparability of financial statements of different firms in the same industry.
  • Full disclosure-the convention is based on the rule of honesty in the preparation of financial statements. It states that all the relevant material facts relating to a transaction should be disclosed fully in the preparation of the financial statements (Ramos 1994). This concept fosters the reliability of the accounting information by users in decision making.
  • Conservatism or prudence- the convention states that business people should never anticipate any profit, but provision for losses should be made.
  • Materiality- the convention guides accountants in the preparation of financial statements. It states that an item is relevant materially for inclusion in the financial statement if it has significance influence in the decision making (Whittington 2009).

The cash basis of accounting states that revenue should only be recorded once cash is received and not when it is earned. It also states that expenses should be recorded when cash is paid for them and not when they are incurred. It basis its foundation on the collection-payment rule and not realization-incurrence rule of accrual accounting. This concept of accounting is not in agreement with the matching principle concept of accounting. All the financial statements prepared on this basis do not reflect the actual financial status of a business entity. It does not conform to the generally accepted accounting principles.

Cash Accounting versus Accrual Accounting

Cash basis of accounting is advantageous because it is easy to operate since it is based on cash held at hand while accrual basis is difficult since it deals with cash which has not been received (Ramos 1994). Accrual basis conforms to the generally accepted accounting principles while cash basis does not. Accrual basis produce financial information, which is accurate and represent the current status of a business entity while cash basis does not report the current financial status of a business entity. This is based on the rule of true and fair value of financial statement at a given time. The main problem with the accrual basis is that of estimation by the accountant in the preparation of the statements. This is because the invoices values do not tally with the estimated figures. In cash basis, the problem is not there since the concept deals with the present situation.

In the case of this discussion, Andrew should apply the cash basis of accounting at the beginning of the year 2013. This will incorporate all his plans of moving to a new location where he is supposed to pay a lease agreement for the business entity. Andrew is also considering buying furniture on a hire purchase agreement. If he adopts the cash basis of accounting, it will affect his tax position. He will not be able to claim input tax under the year of consideration because expense has not been paid. The lease agreement will lower the rental money to be paid by Andrew and thus a higher profit reporting (Riahi-Belkaoui 2003).

Adoption of cash basis in a business entity has significance impact on the tax position of that business. Andrew payment of the lease agreement will be treated like an asset and should be deducted during in preparation of financial statements. This will reflect a true cash position for taxation of the business (Whittenburg 2011). The motor vehicle bought during the year will be depreciated over its useful life, and the expense posted correctly in the books of account. This will improve the accuracy of the financial data to be used to calculate the tax position of the business (Flamholtz 1987). Loss on sale of the motor vehicle should also be incorporated in the calculation of the profit or loss for the business so as to report the actual financial status of the business.

All the cost of goods sold should include purchases on credit and stock on hand whether they are paid for or not. Andrew should consider changing the policy of the business of selling on account. This will help in adoption and proper implementation of the cash basis of accounting. One of the major advantages of cash basis of accounting to Andrew is its simplicity. The system is easy to implement and understand all the procedures (Flamholtz 1987). Andrew will not be able to claim the allowance when using the cash basis like the case of the accrual basis. Also, the extent to which he may recover on tax relief is limited only to the year of consideration. Interest on loan in the year 2013 is predicted to go high according to data provided. Andrew will be limited on the amount of interest he can claim (Nikolai 2010).

Conclusion

The purpose of this essay is to discuss both cash and the accrual basis of accounting and making a comparison of the two. The conceptual accounting framework is beneficial to practitioners in their day to day activities. All the accounting concepts and conventions should act as the compass to the accountants in the preparation of any financial report. This facilitates the comparison of the financial statements of the various firms in the same industry. Objectives of financial reporting and accounting are to provide useful information to current and prospective investors and creditors. This is to facilitate in decision making for investments and also credit granting. The information must be comprehensible by those who have reasonable knowledge of business and economics and are willing to study the reports. Taxation of a business is affected by the accounting concept applied. Accrual basis of accounting enables on to reclaim for input tax in the year of income. This is opposed to cash basis concept, which postpones claim until the actual events take place.

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