Accounting is the language of any business. It is the method to keep count and the way to work out how far a business is financially healthy and strong enough. The triumph of any business depends to what extent one is able to understand the financial terms and also that understanding includes the ability to make out financial business decisions from the various financial reports.
In simple words, an accounting method is considered to be a set of rules used to find out when and how an income or an expense is reported in the business. In fact, there are two methods of accounting used by businesses: cash method and accrual method. In the cash method of accounting, income is recorded only when the cash is received from the customers and an expense is recorded only when a check is issued to the vendor. In the accrual method, an income is to be recorded when a sale is made regardless of when the amount get paid and an expense is recorded while goods or services are received, though the amount may not be paid now and paid later.
The timing of recording the income and expense is the fundamental difference between these two methods of accounting. The excellent method of accounting for any company depends on a number of factors like the nature of the business, the size of the organization, its legal business form and whether or not it extends credit to its customers and avail credit from its suppliers.
This paper highlights the following key issues relating to cash and accrual method accounting and suggests ways to minimize the problems:
Why most of the businesses use accrual accounting method instead of cash accounting method?
Is it true cash accounting is more suitable to current trend of many big business failures due to fraud?
Is it true accrual accounting method is outdated from current bookkeeping system? (cannot handle current complex operation problems)
KEY WORDS
Accounting methods, accrual basis, cash basis, business failures, and frauds.
CASH AND ACCRUAL ACCOUNTING - A BLENDING REQUISITE
INTRODUCTION
Accounting is the language of any business. It is the method to keep count and the way to work out how far a business is financially healthy and strong enough. The success of any business depends to what extent one is able to understand the financial terms and also that understanding includes the ability to make out financial business decisions from the various financial reports.
In simple words, an accounting method is considered to be a set of rules used to find out when and how income and expenses are reported in the business. In fact there are two methods of accounting used by businesses: cash method and accrual method. In the cash method of accounting, income is recorded only when the cash is received from the customers and an expense is recorded only when a check is issued to the vendor. In the accrual method, an income is to be recorded when a sale is made regardless of when the amount get paid and an expense is recorded while goods or services are received, though the amount may not be paid now and paid later.
Cash method
The timing of income and expense recording is the fundamental difference between the two methods. In the cash method, income is recorded only when cash is received from the customers. An expense is recorded only when a check is issued to the vendor. Cash method of accounting is used by many individuals for their personal finances because it is easy to understand and less time-consuming. But this method can distort the income and expenses, especially when credit is extended to the customers and if goods are bought on credit from the suppliers.
Accrual method
In the accrual method of accounting, income is recorded while the sale occurs regardless of when the amount is paid. An expense is recorded while goods or services are received, though the amount is paid later. The accrual method gives a more accurate picture of the financial situation than the cash accounting method. This is because the income is to be recorded on the books of accounts when it is actually earned, and expenses are to be recorded when they are incurred. In this method, in order to get a better picture of the net profits, income earned in one accounting period is accurately matched with the expenses that correspond to the same accounting period.
So in the accrual method, expenses are counted when goods or services are received and income is considered to be counted when the sale occurs and there is no need to wait until money is actually paid out from the cash or bank account or until money is actually received. For example, a new computer is purchased on credit in May and RM3, 060 is paid for it in July. Using cash-method accounting, RM3,060 payment is recorded in July when the money is actually paid. However in the accrual method, payment of RM3, 060 would be recorded in May, when the computer is taken delivery and required to pay for it. Likewise, if the business finishes a job on September 30, 2010, and doesn't get paid until January 10, 2011, the payment is recorded only in January 2011 if cash method is followed. In the accrual method the income would be recorded in the books in September of 2010 itself.
The method of accounting, cash or accrual, is important for income tax purposes. For instance, if expenses are incurred in the 2009 tax year but not paid until the 2010 tax year, it is not possible to claim them in 2009 if cash method is used. If the accrual method is used, it is possible to claim them in the tax year 2009 as the very core of that system is to make entry in the books when the transaction occurs, not when money is actually paid.
Illustration 1
Fina runs a small flower shop called Fina's Petals. On August 22, 2010 Fina buys a set of new lights for her shop for which she is billed RM400. She installs the lights the same day, but doesn't pay for it for 30 days as per the terms of purchase. If she follows accrual system of accounting, she counts the RM400 expense during the September 2010 accounting period, even though until next year January she didn't actually write the check. It means that Fina can deduct the RM400 from her taxable income of 2010.
Illustration 2
Mona and Lisa run Stitch in Hide, a leather product repair shop. Mona and Lisa were hired to repair an antique nature leather couch, and they finish their work on 15 December, 2009. They bill the customer for RM750, which they receive on January 20, 2010. As they use the accrual method of accounting, Mona and Lisa count the RM750 income in December 2009; because it is the period they earned the money by completing the job. As such this income must be reported in their 2009 tax return even though they did not receive the money that year.
Research Problem
Whichever method is used, it's important to realize that both methods will give only a incomplete picture of the financial position of the business. The accrual method may leave one in the dark as to what extent cash reserves are available though it shows the flow of business income and expenses more accurately. For instance, the income ledger may show thousands of Ringgits in sales, while in reality the bank account is empty because the customers haven't paid yet.
Though the cash method will give a correct idea of how much actual cash is available in the business, it may offer a incorrect picture of long-term profitability. For instance, under the cash method, the books may show one month to be amazingly profitable, while actually sales is less and, by mere co-incidence, a lot of credit customers might have paid their bills during that month. In order to have a correct understanding of the business's finances, one may need more details than just a collection of monthly totals; one need to understand what the figures mean and how to make use of them to answer particular financial questions.
The following highlights key risks and problems specific to cash and accrual method accounting.
Why most of the businesses use accrual accounting method instead of cash accounting method?
Is it true cash accounting is more suitable to current trend of many big business failures due to fraud?
Is it true accrual accounting method is outdated from current bookkeeping system? (cannot handle current complex operation problems)
Objectives of the Research
The objectives of the research are:-
To help companies choose the best accounting method based on the companies' business.
To identify the pros and cons of the cash method and the accrual method in accounting.
To help company achieve a high profit in the financial statement.
To provide correct accounting information to make some important business decisions.
SCOPE OF STUDY
The scope of this study includes:
Comparison between cash accounting and accrual accounting method.
To identify the business that applies cash accounting or accrual accounting method.
To find out the implications in adopting cash accounting and accrual accounting method in the operational bookkeeping system.
Survey of Literature
D.E.Van Gieson (2006), while writing the article "Cash Basis vs. Accrual Basis of Accounting" explained that the cash basis focus is on the flow of cash. That is to say, whenever cash is collected, revenue is recognized as having been earned. A similar basis for the recognition of the expenses is used, namely whenever cash is paid out, the related expense is recognized as having been incurred. He also mentioned that the accrual basis does take into account the fact that a business entity's life will extend into the future, beyond the current period. This line of thought is embedded in the on-going or continuity concept of GAAP.
The article "How to Select Your Accounting Method" on www.toolkit.cch.com explained that the cash method is the simplest in that the books are kept based on the actual flow of cash in and out of the business. Under cash method, income is recorded as and when it is received, and expenses are reported as and when they are actually paid. In the accrual method, income and expenses are recorded as and when they occur, irrespective of the fact whether cash has actually changed hands or not.
The article "Cash Accounting Method" posted on the www.nolo.com defined that "cash accounting is simply checkbook accounting, where the cash receipts are listed as and when the customers pay and the money is deposited in the bank as the sales income. When a check is written to pay for a bill or to pay for an expense, the amount of the check is deducted from bank balance, which show the current cash balance".
The article "Cash Method Accounting", posted on www.toolkit.cch.com said that the cash method is very simple to use, because when you get money from a customer or other debtor, or when you make payment of an expense with cash, credit card or check you record.. Under the cash method of accounting, income is recognized when it is actually received. By contrast, accrual method requires you to record transactions when they occur, not necessarily when cash changes hands. Under the accrual method, business income is recorded when sale occurs, regardless of when you get paid. The article also states that the accrual method recognizes an item of expense when it has to be paid for whether or not it is paid in the same year.
An article "Cash vs. Accrual Accounting", posted on the www.nolo.com mentioned that both cash and accrual accounting method differ in the timing only i.e., when sales and purchases are credited or debited to the books. Income is counted only when actually received and expenses are counted only when actually paid if cash method of accounting is used. But under the most practiced accrual method, transactions are counted whenever they take place irrespective of when the money is really received or paid.
Another article "Accrual vs. Cash Based Accounting", on www.epchina.net defined the accrual accounting as sales are recorded when the sales occur, no matter when you are paid. Expenses are incurred when you receive goods or services, though you may not pay the bills for them until a later date. The definition of cash accounting in this article is sales are recorded when you receive the money and expenses are incurred when you pay the bills.
An article "Managing Your Cash: Cash vs. Accrual Accounting" on the web site www.business.lycos.com stated that cash accounting is based on real time cash flow. In cash method, expense is reported when it is paid, and income is recorded in the books of account when it is received. But with accrual accounting, income is recorded when it is earned, not when it is paid. Similarly, expenses is recorded when obligation arises, not when you pay it.
In the discussion "Ask Alice about Cash vs. Accrual Method" posted on the web site www.toolkit.cch.com it is stated that many individuals use cash method of accounting for their personal finances because it is easy to understand and less time consuming. However, she also stated that cash method can distort business's financial picture, especially if extend credit to the customers and if you buy on credit. Income earned is correctly matched against expenses that correspond to the exact accounting period.
An article "Who Can Use the Cash Method" posted on www.toolkit.cch.com said that although the IRS allows all businesses to use accrual method, most small businesses could instead use cash method for tax purposes. It states that the cash method can offer more flexibility in tax planning because sometimes the receipt of revenue or payment of expense is shifted from one tax year to another.
"Cash vs. Accrual Accounting", the article posted on www.toolkit.cch.com stated that cash method is easy to keep as one need not record income until cash is received and need not record expenses until cash is paid. With accrual method, typically record more transactions and accrual method gives a clear view of the financial status of a business.
The appropriate use of cash method is for income tax reporting and paying purposes. However it more closely matches income to the same set of expenses. Accrual provides a true picture of ultimate profit and loss once the eventual cash transactions take place and is therefore more appropriate to draw conclusions from and base informed management decisions upon.
An article "Cash Accounting Method" wrote by William J. Ransom (1995) stated that cash accounting is simple and easy to setup, operate and understand. However, he said, to have accounting information accurate and useful in decision making, accrual double entry accounting method should be adopted when possible.
An article "Accrual Method Accounting" posted on www.toolkit.cch.com described that accrual method gives more accurate picture of financial situation than cash method. Income earned in a period is accurately matched against the expenditure that corresponds to that period. However, another article "Cash Method Accounting" states that although accrual method gives more accurate picture than cash method, the accrual method can also be very complicated.
It is also stated that accrual method is more desirable if has a lot of compound transactions during the year. By using accrual method, net income is evened out, avoiding income 'peaks' that are liable to higher tax rates. It is more difficult to reduce taxes by changing items of income and expense from one accounting year to another accounting year under accrual method. In cash method, the owner can control expenses to some extent by deferring or accelerating some payment for items such as advertising, taxes, supplies etc.
An article "Accounting: Cash vs. Accrual" wrote by Milton Zall (2001) said that, under the accrual system of accounting, a company is required to remit taxes with money it doesn't have, which could be quite a big burden for a small company.
Research Methodology
Information and data of this research were gathered from various sources of secondary data. Sources of these secondary data include journal articles published in magazines such as the Journal of Accountancy and online articles downloaded from the Internet. From the secondary sources enumerated above, the research framework is developed:
Cash Accounting
Accrual Accounting
Merits
Demerits
Merits
Demerits
BLEND
Controls
Research Framework
Comparison between Cash Accounting and Accrual Accounting
Issues
Cash Accounting
Accrual Accounting
1. Timing of transactions recording
Recognizes transactions only when cash is received or paid.
Recognizes transactions when the obligation or event occurs. Transactions and events are recognized in the accounting period in which they relate.
2. Reporting objectives
Gives full account of the receipts and payments made in the reporting period.
Present fairly the financial performance for the period covered by the accounts and the financial position as at the end of accounting period.
3. Recognition of assets
Treat all payments the same way and does not distinguish between payments of a revenue nature or capital nature.
Distinguishes between revenue and capital expenditure, and recognize assets as being expenditure which will generate economic benefits for longer than the current year.
4. Recognition of liabilities
Basically does not recognize any liabilities.
Recognizes a liability when an obligation to pay arises.
5. Matching
Transactions are recorded when cash is received or paid, without regard to the matching of revenue with the related costs.
Matches revenue with related costs so far as their relationship can be established or justifiably assumed.
Discussion, Analysis and Findings
All businesses need to select one of these systems of accounting: cash or accrual. It is important for an entity to understand the basics of these two principal methods of keeping tract of business's income and expenses. In general, these methods differ in the timing of when the transactions both sales and purchases are credited or debited to the books of accounts. If the company uses the cash method of accounting, income is counted when the cash (or a check) is really received and expenses are recorded when actually paid. But in the most common accrual method of accounting, transactions are counted when they actually happen irrespective of when the money is actually received or paid. The companies don't have to wait until the companies see the money or until money is actually paid out of entity's bank account.
Each method has its own advantages and drawbacks. Overall, accrual method shows the performance of a business over a time by matching income and expenses (matching concept applied). It is because this method recognizes the income when a sale is made regardless of the cash flow. It also will help the company to have accurate accounting which can be used to make some important business decisions. This is due to making some decisions on correct and current financial data is a basic necessity to run a successful business. Accurate information can be obtained when the company record income on the books of accounts when it is actually earned and expenses are transacted when they are actually incurred. So the company will get a better view of net profit for each period. On the other hand, the accrual method may create many unnecessary accounting headaches, such as it is very difficult to lessen taxes by changing the income and expenses from one accounting year to another accounting year. The accrual method will produce time difference between the recognition of income and expenses and the real inflows and outflows of cash. Because of the time difference, the accrual basis of accounting leads to many problems in accounting and thereby showed the way to many accounting scandals. To mention a few:
ENRON
Enron's scandal is a notable case in point of accounting and auditing issues. The fraud case of Enron that resulted to the bankruptcy of this energy company, has been the most issues discussed and debated by all academicians and particularly business practitioners. Enron is an energy company that based in Texas. The Enron's fraud case also has resulted to the suspension of Arthur Andersen, one of largest accounting firm in the world. The bankruptcy was reported in December 2001, and it became one of the greatest bankruptcy cases in US.
The reason of this audit failure by Enron is due to some unethical behavior and circumstances by the Enron's senior management. One of the major causes is the adoption of murky accounting technique. Enron used mark to market accounting practice in order to shrink the tax payments, to increase the stock price, income and profits amount, to conceal the debts amount and also to misrepresent their financial statements to the public. Enron also employed special purpose entities. This special entity was created by forming companies or partnerships to carry out special function and resulted the amount of debts been hide from the financial statements. Consequently, the balance sheet has overstated the income and understated all the losses and its liabilities.
As the effect of Enron's fraud case, the government of US has come out with Sarbanes-Oxley Act 2002. As per this act, all the public companies must comply with the complete and comprehensive accounting procedure so that all the financial statements presented to the public will be more transparency and maintain true and fair view. By observing on this act, it also will help to improve on the integrity, quality and performance of the auditors.
WORLDCOM
WorldCom was another culprit of the improper accounting practices. In April 2001, WorldCom management decided to transfer transmission line costs from current expense accounts to capital accounts. This allowed them to defer some operating expenses and report higher earnings. Also, through acquisitions, they seized the opportunity to raise earnings. WorldCom reduced the book value of hard assets of MCI by $3.4 billion and increased goodwill by the same amount. Had the assets been left at book value, they would have been charged against earnings over 4 years. Goodwill, on the other hand, was amortized over a much longer period. In June 2002, the company declared a $3.8 billion overstatement of profits because of falsely recorded expenses over the previous five quarters. The size of this fraud increased to $9 billion over the following months as additional evidence of improper accounting came to light.
SATYAM COMPUTER SERVICES LIMITED
Satyam Computer Services (India), was incorporated in 1987 by Founder and Chairman Mr. Ramalingam Raju before it went public in 1992, taking the name Satyam Computer Services Limited. Thereafter, the Company has grown to become India's fourth largest software services company and was part of the $7.1 billion Mahindra Group, a global industrial conglomerate based in India as stated in Mahindrasatyam website.
CNN-IBN (2009) reported that Satyam Computer Services Limited scam began to surface in mid-December 2008 when Satyam's Chairman, Mr. Ramalingam Raju announced to buy 100 per cent stake in two companies owned by his sons - Maytas Properties and Maytas Infrastructure at US$1.6 billion. The deal failed after severe criticism from investors and analyst dubbed it as one of the worst corporate governance events in India. The company's shares took a dive on the bourses and it lost US$2 billion on the New York Stock Exchange. On 23rd December 2008, Satyam Computer Services Limited was banned by World Bank for eight years for bribery and data theft.
On 7 January 2009, the Chairman of Satyam Computer Services Limited, Mr. Ramalingam Raju announced his resignation after confirming to the Board members and Exchange Board of India (SEBI) that the Company's accounts for year ended 30 September 2008 has been falsified. He confessed the inflated figures were 71.36 billion rupees (US$1.54 billion) (World Business, 2009). As stated in Wikipedia, the inflated figures were partly from cash and bank balances which has been overstated by US$1.07billion, non-existent interest entry posted US$80.09 million, understatement of liabilities of US$261.99 million and overstated of debtors of US$104.37 million.
Further investigations revealed that there were unethical practices by Satyam officials:
exaggerating revenue by creating fake customers and invoices by 4.3 billion rupees (US$93.1 million)
(ii) forged documents to obtain loans or advances worth 12.2 billion rupees (US$264.1 million)
misuse of funds by Company officials who used their fraudulent acquired funds to buy more than 1,000 properties worth 3.5 billion rupees (US$75.8 million) and
misleading financial analysis in order to obtain personal gains. Raju and his associates has gotten 19.3 billion rupees (US$418 million) by pledging their shares in the company at inflated values and generated billions more with other stock scams, as said in a statement of World Business, 2009.
However, all the above problems under accrual accounting could be solved by:
Auditor independence.
Director independence.
Appropriate Executive compensation schemes and
Appropriate accounting practices.
The cash method of accounting is very easy to understand and to use and less time-consuming. It is more closely resembles the company's cash flow because it more concerned with actual inflows and outflows of cash instead of matching income and expenses. It also is easier to maintain because the companies don't record income until the company receives the cash and the companies don't record expenses until the cash is paid. This method can offer more flexibility in tax planning because the entity can sometimes shift these items form one tax year to another. On the other hand, this method will distort business's financial picture, especially if the company extend credit to customers and if the company buys on credit.
Another standpoint that the company should take into consideration is the effect of each method in tax point. It is sometimes better for a company to use the cash method of accounting under which recording income can be postponed till the next tax year, while expenses are recorded right away. In other hands, this method can offer flexible tax planning for an entity to decrease their tax liability. In the accrual method, the company has to pay income taxes on the revenue that the companies haven't received it.
A number of entrepreneurs will find good news in a recently issued IRS procedure allowing certain businesses with gross receipts of up to $10 million to use the cash method for income and expenses rather the accrual method. Thus now there is awareness with the need for cash accounting in lieu of accrual accounting.
In adopting these two methods, the company should consider various factors like:
The size of the business.
The form of business.
The nature of business: physicians, contractor, doctor, lawyer, accountant and etc.)
The income tax law of the country.
Credit transactions.
Many accountants recommend the use of accrual method because they consider it to be the most accurate method of accounting for measuring how the business is doing.
The net results produced by the cash as well as accrual accounting methods of accounting will only differ if the company carry out some transaction on credit. If all the company's transactions are paid in cash as soon as the business deal is completed, including all sales and purchases, then the ledger accounts will look like the same, regardless of what method of accounting is used by the enterprise.
CONCLUSION
Whichever method of accounting is used, it is important to understand that both methods give only a partial picture of the financial position of the business. While the accrual method of accounting shows the business income and debts more accurately, it may leave one in the dark as to how much cash reserves are available. For example, the income ledger may show few thousands of dollars in sales. But in reality, the bank account may be empty because the customers haven't paid the company so far. On the other hand, though the cash method will give a real idea of how much actual cash is available in the business, it may give a misleading picture of long-term profitability of the organization.
Both of the accounting methods cannot replace by each of other because the company must consider various factors in adopting one of these methods, such as needs and requirements of specific bodies and entities. Type of the entity also must be taken into consideration when selecting between these two accounting methods. Every company will adopt the accounting method based on various important criteria that work best to the company. Essentially, the company should be responsive with the accounting method that they want to implement, so that the Enron-like case will not transpire in the company itself. In addition to that, the company should always encourage their employees to remain faithful and loyal to the ethical standards and behaviors for the benefit and best interest of the organization.
