The accounting profession generally supports the view that accrual accounting provides a better indication of an enterprise's current and future ability to generate cash flow than information based on cash receipts and payments. With reference to a company of your choice (i) explain the difference between accrual and cash accounting, (ii) explain why accrual accounting is a better indicator of future cash flow, and (iii) explain any problems or limitations of accrual accounting.
The Difference between Accrual and Cash Accounting
Both the accrual and cash accounting methodologies are acceptable accounting techniques to be applied the company's management to their business's accounts. Generally the cash method is used by the small businesses. In this method, expenses and income transactions are not counted until they are completed, i.e. cash is received as income and is then paid as expenses. The cash method is generally easy to apply, hence the small business owner can use it simply without the need of an accountant. Conversely, the accrual method is more complex and requires the company to have professional accounting skills if they are to correctly apply it (Donleavy 1994).
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When using the cash method, the money is put in the cash records as soon as it's received and accounted for as soon as it's paid out. For example, if the Dell Computer Company (Dell) were to apply the cash accounting method, as soon as a customer pays for a computer from Dell, the money would be entered in the books immediately the cash is received. However, if Dell has good and services it has not paid for, for example its electricity bills, money to be paid for repairs done or money for ordered spare parts, these amounts are not entered into the books, as no cash has been paid out. Conversely, the accrual method would take into account all economic transactions in relation to the company. Since Dell is NASDAQ listed future 500 company, it is required to apply the accrual accounting method (Dell 2010).
The accrual method and respective statements are structured in line with the generally accepted accounting principles. This method aims to ensure the timing of the expenses and revenue of the business are well matched. This means that the sale of goods and services are recorded as soon as an invoice is received, or the goods and services have been delivered. Unlike in the cash method, the cost of goods and services delivered is recorded regardless of whether the company has received the cash or not. In addition, any expense that has been incurred and is payable or due is also recorded (Donleavy 1994). As a result even if the company will not be paid until next month, the expected monies are still recorded. This method provides very important data used in the performance of a company, since any economic event is recognized and recorded. For example, in applying the accrual method, Dells expected cash outflows/inflows and current cash outflows/inflows are combined. These kinds of records are very important for Dell, as the company generally achieves a Total Net Income of approximately 2.5 Billion US dollars a year (Dell 2010).
Accrual Accounting Is a Better Indicator of Future Cash Flow
Predicting the future cash flow is very important for any investment. The accrual method has been commonly referred to as the most accurate method for determining this. However, there has been inconsistency globally in the application of accrual and cash flow accounting standards. For instance, there has little research done in many Asian countries on the prediction of cash flow.
It can be argued that the accrual method is the only method that accurately represents the actual financial state of the company. For instance, while Dell may hold at times large sums of cash, trying to determine the future cash flow as a result of the cash in its accounts may be misleading as Dell may also hold debts for unpaid good and services received. In addition, while the cash method provides accountants with accurate tax liability in accordance with the credit control practices and policies, the tax liability may be inaccurately higher or lower while using the cash method. As a result , the accrual accounting has been noted to provide superior information making it easy for companies to predict future cash flows.
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When analysing accrual accounting, different components are included to represent different information which is in relation to the future cash flows. For example, productivity is enhanced by amortization, depreciation, inventory change, and change in payable account, change in receivable accounts as well as other accruals recorded. Each of these components including the cash flow are more sustainable predictors of the future cash flow in contrast to having aggregates of earnings.
Limitations of Accrual Accounting
An accrual account identifies the money held after a business transaction has been done. While in some instances the cash received may not be paid in full requiring an adjustment on the previous records, although generally the cost for products and services received are easily determined. For instance, by applying the accrual method Dell's management is in a position to determine the economic performance of their products before paying for them. Conversely, it would be much more difficult for Dell's management to access the product performance by assessing the cash received in its account.
Under the accrual method, ensuring that taxes are minimized by expenses and income items from one year to another year is very difficult. This is not the case with the cash method. The company's management is in a position to collect interests, rents any other obligation in advance while deferring tax payments. In addition, the company's management can adjust expenses by deferring or accelerating payments such as taxes, interests, repairs, suppliers and advertisements. Conversely, when applying the accrual method, such controlling not as easily achieved. In the instance of Dell, management can defer part of the income to the following year by delayed invoicing and shipping less goods and services, although the resultant impact cash flow is not readily accepted by Dell's stakholders.
Accrual method may result to some serious cash flow problems since it does not give details on the cash reserves available (Watts and Zimmermann 1986). For instance, the income ledger prepared for Dell's transactions may indicate that the company has one million dollars while actually the account reads one thousand dollars as a result of some clients not paying for their goods received. This is misguiding when making decisions on what to invest. In addition, the accrual accounting method is a detailed process and requires that at each accounting period end, some closing entries be posted. In this instances due to the complexity of the accounting required, some companies may hire a contracted accountant to assist them and as a result create additional costs to the company.
In conclusion, while the accrual accounting method is more complex than the cash accounting method and at times more costly to implement, it provides the company's management with a more consistent representation of the company's accounts and future cash flows and provides management with better information in order to strategic steer their company towards better economic performance in the future.
a) Prepare an income statement for the year ended 31st December 2009, and a balance sheet as at that date, for Richard plc. The balance sheet and income statement should follow a format recognised by accounting standards and you should ensure that you show your workings clearly.
b) Although IFRS is being used in many countries worldwide, financial statements are not yet truly comparable on a global basis. Briefly explain whether or not you agree with this assessment and state your reasons.
a) Balance Sheet & Income Statement
b) IFRS Statement
Although IFRS is being used in many countries worldwide, financial statements are not yet truly comparable on a global basis, is an agreeable statement. Despite the use of IFRS in several counties, it is generally not yet possible to compare financial statements globally. The main issue stems from the fact that IFRS has kept on evolving. Initially, the International Auditing Standards (IAS) was being applied, but was later revised and changed to IFRS. As a result, there has been little time for companies to fully and properly implement these accounting standards.
Secondly, there has not been a smooth transition to IFRS and in many cases there is need for updated technology as a key enabler (The American Institute of Certified Public Accountants 2010). This means it is difficult to compare financial statements across different counties as there has been different technological advancements. For instance, some countries are able to adopt IFRS easily due to their technological strength, whereas others, especially the third world counties are still behind technologically. In addition, there is a challenges within companies to transition from their previous financial statement methodology to the new IFRS ones.
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Not all the counties of the world that have embraced the IFRS. There are some countries like the United States, who have continued to use previous method until recently. For the United States, it had been using Generally Accepted Accounting Principles (GAAP) and it has not been mandatory for its companies to follow the IFRS. Instead, for many countries their Securities and Exchange Commission (SEC) have required listed companies to apply IFRS, as mandatory. While in the United States the SEC recently approved 2015 to be the earliest date for any public company to be required to use the IFRS (Defelice 2010). For other countries like the Mexico announced they would start adopting IFRS in 2012 (American Institute of Certified Public Accountants 2010).
The difference in adoption times makes it difficult for financial statements to be compared globally. In addition, many countries experience different economic growth rates. Some grow faster due to historical strength and available resources, while others grow slowly. This means applying a single globally accepted standard for financial statements may by some time off into the future, although it is the pragmatic steps made by each company operating with each country striving to reach a common goal in order to achieve a globally accepted best practise accounting standard.
Defelice A, & Lamoreaux, M., 2010, Journal of Accountancy, [internet]. Available from http://www.journalofaccountancy.com/ [accessed 28th February 2010].
Dell 2010, Dell Financials [internet]. Available from http://i.dell.com/sites/content/corporate/secure/en/Documents/FY10_Q3_SEC_Form10Q.pdf [accessed 20th February 2010].
Donleavy, D, 1994, Cash Flow Accounting: International Uses and Abuses, London, Routledge.
The American Institute of Certified Public Accountants, 2010 [internet]. Available from http://www.ifrs.com/Backgrounder_Worldwide.html [accessed 22nd February 2010].
Watts, L, and Zimmerman, L, (1986), Positive accounting theory, New Jersey, Prentice-Hall, Inc, Englewood Cliffs.