Cash flow accounting, accrual accounting, which ones better
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Published: Mon, 5 Dec 2016
It is argued occasionally, cash flow accounting or accrual accounting which one that can be provided better information for users. Leading to the primary basis on which the financial results of companies are reported.
Firstly, the report would talk about review of the extant literatures between cash flow and accrual accounting’s role and intention of corporate reports. Secondly, evaluating which accounting basis satisfies the informational needs of users and implications of adoption for preparers. Finally, the report would also make some recommendations for a future improved disclosure rule.
Methods of accounting in financial statement
First of all, what is the primary objective of financial statement? ‘Financial statement is to provide information about financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions.’*1 That is stated by International Accounting Standards Board (IASB). For providing information of financial statement, there are two accounting methods for companies to report their financial statement. Cash accounting and accrual accounting both are the main method to prepare the financial statement.
Cash basis accounting is a very basic form of accounting. ‘Revenue is recorded only when the cash is received, and an expense is recorded only when cash is paid. Preparing an income statement under the cash basis of accounting is prohibited under generally accepted accounting principles.’*2 For example, when a payment is received for the sales of product or services and the revenue is also recorded the date of receipt. On the contrary, when a cash or check is paid for some invoices and the expenses are also recorded the date of paid. That is the cash accounting entries in the financial statement because the main focus point of cash basis is cash. So any transactions are related to cash on that day, cash accounting is also recorded as expenses or revenue on that day.
Accrual basis accounting is combined together with the revenue recognition principle and the matching principle as a combined application. ‘For example, using the accrual basis to determine net income means recognizing revenues when earned (the revenue recognition principle) rather than when the cash is received. Likewise, under the accrual basis, expenses are recognized when incurred (the matching principle) rather than when paid.’*3 Accrual accounting compares to cash basis accounting to be more complex because it includes account receivables (amounts receive from debtors on credit sales) and account payables (amounts pay to customers on credit purchases) that can be matched the revenues are earned and the expenses are incurred to the time period. ‘The effects of transactions and other events are recognized when they occur, rather than when cash or its equivalent is received or paid, and they are reported in the financial statements of the periods to which they relate.’*4 For example, when selling a new computer in March, but the customer does not pay the bill on time until two months later. The company would record the income on credit in March in their accounting books under accrual method that is different from cash accounting.
According to upper side, cash basis and accrual basis are totally different accounting methods for providing information to prepare financial statement. In revenue and expenses, cash and accrual method are recorded when they are received and paid or they are earned and incurred respectively. Cash method reflects revenue and expenses based on cash were received or paid on that day. But accrual method is matched revenue and expenses when they are incurred in time period. At last, cash accounting is no receivables and payables that is also no available method for tracking the recognition of transactions. That means accrual basis giving more meaningful and useful corporate reports.
Advantages of accrual accounting and cash accounting
In accrual accounting, it have a concept when measuring same activities, it provides more steady financial performance and more accurate for prediction because of consistence of performance. And using historical data for preparing financial statement, it can be more reasonable truth and predictability that it is relatively objective. This means that the figures produced in financial statements are objective and not manipulated by a person that can be controlled the company. So that, providing information by accrual basis makes it easier to predict future earnings and financial position.
In cash accounting, the data are also objective and no judgment can be make as each value or amount are recorded by cash transaction with a third party. It can observe easily a company for survival in the short term, but in order to survival in the long term that the business must be make profit. Then, there is no requirement or compliance for accounting standards or disclosure of any accounting policies so that it is more easily to prepare. A more accurate picture of the amount of actual cash is provided by cash method in company’s business. The preparing time and cost can be reduced if comparing to accrual accounting. Due to cash basis is no non-cash accounts hence it does not provide a complete financial operation of the company. Information under this method may not achieve the qualitative features of relevant and reliable.
User’s need analysis
Satisfaction of user’s need is really important because financial statement is used to provide useful information for users to predict or make their own decision. Most of people have an interest to know that the activities of the business. These people are the users of accounting information. Which one would provide better information and satisfy the user’s need? The users also divide by internal and external users. The report will show seven different positions including, employees and management as an internal users and investors, customers, creditors, government and shareholders as an external users to analyze the two accounting methods.
Purpose of the employees finds a job that is mainly to maintain the stable live. So, they highly concern the stability of the job and ability of the company to pay their salaries, remuneration and bonus on times. Their point of view in cash uniquely focuses on it. If the financial statement is used cash accounting method that can indicate the amount of cash in hand easily so the employees can assess the company’s ability to pay their salaries. Moreover, cash accounting for employees is clearly to understand the trend of cash flow than the complexity of accrual accounting.
Management uses the past information in financial statement to emphasis on making future prediction or use in planning in their business. They need to determine the overall review on the trading business what decision should be made or not. The planning directly affects the operating of company in the future so management would review the financial statement as a reference to investigate the future trend or predict the future profit or loss. And management would be set the policy for the company in financial or operating dimensions. Such as credit period for customers that how long of time period should pay the bills, ninety days or hundred days or so on. All of them are depended on the debtors of financial statement so accrual basis or cash basis accounting are needed to provide in that information.
Investors are one of the main users of the financial statement. They need to decide whether the value of company invests or not as they want to assess the company’s profitability and the future performance. Every investor only focuses on higher rate of return in lower risk condition. So, they will assess the financial statement of the company to reduce the higher risk opportunity. Based on previously presentation, accrual accounting is to provide steady net profit pattern that also represent the company having steady operating performance. It can help the investors to make the prediction more accurate.
Although the performance of company is also very important, focus point of the customers is about going concern of the company. They want to know the ability of company to act as a long term partner for trading. So, they would like to see the sufficient inventory level to delivery on times. This can be more easily to control the stock level of their shop or industry to reduce the holding cost. Accrual accounting gives a more accurate picture of profit and loss and the overall financial performance. It should assist the customers to determine the delivery and holding cost for trading business.
Trading business between company and creditors is based on a partnership. Creditors review the liquidity and the ability of company to pay the debt. Cash method can show the cash balance straightly but it does not show the account payable balance on the statement. Because cash method is no account payable or account receivable, it just only demonstrates cash transactions. That means it may not provide complete and sufficient financial information to creditors. For instance, company has an available bank balance about two million. This means that the company has ability to pay the debt. However, the company has an account payables balance over ten million. Consequently, it does not effort the debt to pay. Creditors should focus on overall financial performance that why accrual accounting is much better to present the information.
Regarding to completeness of the corporate report, accuracy and the compliance with accounting standard, government is mainly concerned them. Cash accounting does not have any disclosure requirement and more complex reporting but accrual accounting is commonly used in every company (listed or non-listed) in the world compliance with International Accounting Standards (IAS). Therefore, accrual accounting would be more suitable for government that is persuasiveness because of followed by IAS.
Shareholders are the owners of the company. They just know the profit of company and dividends at each period to pay. Because they have the ownership of company, they also consider the going concern problems. Review the overall performance of the company that is the purpose to reach the primary objective of making profit. The dividend payout is depended on the amount of net profit that the company earned in the year. If the current year is no net profit made, the company may not payout any dividend in that year. That moment, the shareholders are disappointed that may lead them to divest the company. In accrual accounting provides more steady net profit pattern and more accurate picture of organization the finances. Inversely, cash accounting is directly affected by cash so that it is more fluctuated. In this situation, accrual accounting can predict the net profit and dividends according to historical information.
The comparison of the above, investors, customers, creditors, government and shareholders are supported accrual accounting. All of them are external users thus all of financial statement reports to external users under accrual accounting. This shows its information can provide better information of users.
Implications of adoption for preparers
What are the factors that influence preparers to adopt an accounting method? ‘The following were the results of the survey on factors that influence the company to adopt a particular accounting method. Normally, five main factors are influence the preparers. It is included sizes of company, nature of business, complexity, cost and taxation.’*5
Nature of business
Nature of business in the companies may affect to choose which accounting method to prepare the financial statement. Pawnshops and restaurants should apply the cash method because it is easy to determine the revenue amount at that time of the sale. On the other hand, manufacturing, trading and transportation services should use the accrual method because it is difficult to receive the whole of the amount immediately. Some customers would be like to prepay the bill first for trading business. That can be easy to match the revenue and expenses in this transaction under accrual basis. Also, it helps to plan the operating cycle especially in the management of inflow and outflow of cash. So, different nature of business may apply different accounting method.
Size of business
The size of business also affects the adoption of accounting method. For instance, a small size of company will trend to apply the cash accounting because the amount of trading cash flow is not large and the whole company only is a few transactions. So a company uses an accrual basis, they need to train the staffs and establish accrual accounting system for the company. Small company is no enough the staffs and budget to apply accrual basis because they may not have ability to cover the cost of the system. The key point is that they no need to spend lots of money only for a few transactions. It may lead to decrease the efficiency and effectiveness of company than using cash basis.
Accrual accounting requires more complex reporting and disclosure requirements than cash accounting. There is much depreciation accounting method to calculate the fixed asset or current asset in a company. If the company selects a wrong depreciation method, it may lead to the financial statement having a loss in the year from the gain in original. Disclosure requirements in accrual basis are followed by IAS that may be many attachments to compliance. All the accountants in the world must follow because of providing better information to users. So that, companies may concern their employees who have or have not such specified skills to achieve the accounting standards.
Accrual accounting is more expensive than cash accounting. As accrual basis is more complex, all the accountants need to have enough training for preparing more accuracy financial statement to provide better information for users. Training for accountants to achieve the international accounting standards that are higher cost, they need specified and professional skills to complete it and also need regular to update their knowledge and skills. The next point is that company would be established up an accounting system for accrual basis method so that company has ability to effort the budget cost.
The company should balance the cost and benefit to choose the two accounting method which will not adopt accrual basis accounting.
Under accrual method, accrued expenses can partly allowable to deduct in that financial year even if the expenses is not paid yet but the creditors need to reserve the taxes on expenses in accounting books. This obtains a lot of benefits and advantages though tax payable. In cash method, expenses and income are recorded when it is received or paid so it can deduct depending on the customers to pay cash or check on the received time. There is no prediction for the future year of financial position and performance.
Recommendations for future disclosure
‘According to IAS 1, it requires that an entity shall prepare its financial statement, except cash flow information, using the accrual basis of accounting. When the accrual basis of accounting is used, items are recognized as assets, liabilities, equity, income and expenses when they satisfy the definitions and recognition criteria for those elements in this framework.’*6 So, the future financial statement must include cash flow statement. It can show cash flow balance and detail in the year to provide useful information for confirming decisions such as operating cash flows before working capital changes, cash generated from operations after working capital changes and cash flows from investing activities and financial activities that is largely free from allocation and valuation events. This information can assess and review previous assessment of cash flow. ‘Cash flow accounting appears to satisfy the need to supply owners and others with stewardship orientated information as well as with decision orientated information.’*7 It gives users more information about solvency and liquidity of companies and enables them to compare the other similar firms. When using accrual basis method is difficult to make the assumption. If the users just concern the cash balance in financial statement only, this may be easily occur misunderstanding to influence the future economic decision of the users. So cash flow statement must be included in financial statement for a future as a supporting document between the statement of financial position and the statement of comprehensive income.
Between cash and accrual basis method, accrual method is more applicable to company providing better information for the users. It reflects better the true of financial situation of the company and providing a real picture of the business as a reference for users to make decisions. It also matches the right expenses and revenue when they are earned or incurred at the period under matching principle and revenue recognition principle. That’s mean for tracing each transaction or keeping records which may be more convenience for company. Hence, accrual accounting is matched the primary objective of financial statement that is reliable, understandable, relevant and comparable. ‘In professional accounting practice requires reports to external users to be on an accrual accounting basis. This is because the accrual accounting profit figure is a better predictor for investors of the future cash flows likely to arise from the dividends paid to them by the business.’*8 Therefore, accrual accounting finds more advantages to use rather than cash accounting. As a result, the majority of the world of company’s financial statement uses the accrual accounting basis as well.
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