Essay on Accrual Accounting vs. Cash Accounting
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The recording of financial activities in a business is essential in making sure accurate information is provided for decision making. Zafirakis (2005:4) states that "Accrual accounting is the cornerstone of modern accounting procedures." In this essay, the importance of accrual accounting will be considered by looking at how it functions in the Double Entry System and comparing it to cash accounting, another method of gathering financial information. Time and an accurate accounting measurement is what will be considered in determining the importance of accrual accounting.
Double-entry accounting is used to develop accounting data. From this data, we can determine the performance of a business by calculating its profit, revenues -…show more content…
Generally debits and credits equal to one another, ensuring the balance of the accounting equation.
Accrual Accounting attempts to recognize events either before or after those events have been settled in cash (Zafirakis 2005:33). Because we do not consider when the cash transaction has happened, there are four scenarios that require us to adjust entries made in the double-entry system after a financial period of time has passed. This ensures an accurate account of a business' revenue and expense events. To illustrate this, the four scenarios of when adjustments need to be made will be expanded.
We will examine how expenses are recorded in the accrual basis of accounting. One scenario is that of a Prepaid Expense. When we pay for an expense before hand, it becomes an asset. We debit the prepaid expense account and credit the cash account. After a certain amount of time has passed, the expense happens, we adjust the entry by debiting the expense account and crediting prepaid expense account. Another scenario of an expense is when it has happened but a business has not yet paid. This is an Accrued Expense. We debit the expense account and credit the accrued expense account (which is a liability). An example of this is when employees have done their job but the company has yet to pay them. Wages expense is debited and wages payable is credited. Wages payable is an example of an accrued expense.
Recording revenues in an accrual
Accounting has two methodologies to recognize income and expenses: cash and accrual basis. Each method has its merits, benefits and disadvantages. Depending on which you select, you will get a different number for your bottom line. You could have one method for your daily financial needs and another for your year-end tax returns. Many small businesses with no inventory select the cash basis of accounting.
Generally Accepted Accounting Principles (GAAP) are standards and conventions used in the U.S. to provide uniformity in accounting and financial statements. GAAP approves the accrual, not the cash basis, method of accounting. However, many non-incorporated small businesses use the cash method of accounting with no problems. When a small business starts to grow, getting loans and investors, it may consider using the accrual method, which is mandatory if your business has sales of more than $5 million, or if you have inventory and sales of $1 million on an annual basis.
The basic difference between cash and accrual methods of accounting is related to timing of revenues and expenses. Cash basis recognizes revenues when money comes in and recognizes expenses when money is paid out. Cash basis doesn't recognize accounts receivable or payable. For example, only when you pay a bill do you recognize an expense. Accrual basis recognizes revenues when they are earned. That is, the company records revenue when it earns it, even if the customer hasn't paid yet. For example, a contractor using accrual accounting records total revenue earned when he completes the job, even if the customer hasn't paid the final bill. Expenses are handled in the same way. The contractor records any expenses when they occur, not when they are paid.
The difference between cash versus accrual can be huge. Suppose you have a business with these transactions: 1. Received a bill for $4,000 for work done this month by a consultant 2. Paid $100 for a phone bill 3. Sent out an invoice for $10,000 for service fees performed that month 4. Received $100 in fees income If you were using cash basis, your profit for that month would be $0 ($100 in fees income minus $100 in phone bill). If you were using accrual basis, your profit would be $6,000 ($10,000 in service fees minus $4,000 in consultant expenses).
Benefits and Disadvantages
The benefits of the cash method are that is simple, flexible and takes cash flows in consideration. Income is not taxed unless it is received. The disadvantage is that there is no control of accounts receivable and accounts payable, especially long-term ones. Running a business is more than just seeing money come in and out, and cash basis gives you a too-narrow view of business finances. The benefits of the accrual method are that it is accepted by GAAP and gives a better idea of real income and expenses within a time period. The accrual method gives a long-term picture of the business, unlike the cash method. The disadvantage is that cash flow and analysis may go on the back burner. Also, accrual is more complicated than the cash method.
When looking at financial statements or other reports, there are clues that indicate if you're looking at an accrual report or a cash report. An accrual balance sheet, for example, will show a number for accounts receivable and payable, and may present deferred revenues or prepaid expenses. A cash basis report will not show any of these accounts, only cash and owner's equity. When looking at an income statement, ask if the revenue reported is money received only, which indicates a cash-based statement, or if the revenue is made up of invoices sent out, which indicates an accrual-based report.
About the Author
Sheila Shanker is a certified public accountant based in California. She writes online courses for professionals seeking CPE hours and has also published the book "Guide to Non-profits: From the Trenches." Her articles have been published in national magazines such as the "Journal of Accountancy," "Architecture Business and Economics" and "Veterinary Economics." Shanker holds a Master of Business Administration.
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