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This essay is based on financial statements within the accounting system. Accounting is a very broad practise with many procedures and rules. This means that accountants usually have a choice of various ways in which to write out there accounts. The way in which an accountant chooses to produce accounts will generally be dependent on their preferences as well as what and who the accounts are for. An example of this can be seen with financial statements. Benedict and Elliot (2011) suggest that financial statements are summaries and reports of information entered into the books of accounts, for example balance sheets and income statements. There are two main methods to writing up financial statements as they can either be prepared on a "cash basis" or an "accrual basis". Each of these methods have their own advantages and limitations that are better suited to certain situations than others. This essay will compare the two different preparation methods for financial statements. It will compare the two methods by identifying and analysing the advantages and disadvantages of each method. A judgement will then be given on which method is best.
According to "When the cash basis is used, revenues are not recorded until the cash payment is received and expenses are recorded when they are paid for in cash" (Hankins and Baker, 2004). Preparing accounts using the "Cash basis" system means that transactions are only recorded when cash is being transferred. This is an advantage as it results in the accounts providing a good idea of cash flow within the company. However, it does not show the position of the business and its profits accurately as it does not consider earned income and expense such as debtors, creditors, accruals and prepayments. In contrast, Nikolai, Bazley and Jones (2009) explain in their work that, "Under accrual accounting, a company records revenue in the accounting period in which they are earned and realized, and records expenses in the accounting period they are incurred". An advantage of this system is that, preparing accounts and financial statements using the accrual system, means that transactions are only recorded when they have been earned or when they expire, resulting in the accounts giving a better representation of the company's position and having clearer information of transactions. Consequently, because cash movement is non-existent in this system, it restricts this method from giving a good idea of the cash flow.
One of advantage of the "Cash" system of preparing accounts is that it is less demanding as there is less calculations to be conducted, therefore making the system less complex for the writer. This means that novice account writers or accountants with little experience of other systems can perform this. Furthermore, under this system only a limited amount of journal entries and book-keeping transactions are necessary, making for fewer entries into the accounts. The fact that this cash system is easier to carry out has resulted in it being heavily favoured by small business as extra expenses do not have to be spent on a professional accountant to write up the accounts. This belief is supported by J.Tracy and T.Tracy as they state, "Accountants at small businesses may decide to record revenue and expenses through simple cash-basis accounting, which, as the term implies, means recording only cash inflows and cash outflows". On the other hand, preparation using the accrual system, records a greater amount of transactions and historical information making it more accurate, meaningful and reliable but also making it more complex and balanced towards experts than the cash system. This can be seen as a limitation when compared to the cash system, because it is more difficult to produce. Nonetheless, it could also be seen as an advantage as it generates reliability. The accruals system ignoring cash transfer, means it fails to demonstrate the same accurate cash flow within the company as the cash based system which is a limitation. Furthermore, unlike the cash system, a professional accountant may have to be hired, creating overhead and making it more expensive than the cash based system. Different from its counterpart, this system is usually used by bigger businesses as research suggests (Business dictionary, 2012) "The accrual method is generally used for larger businesses that use invoices and maintain a large inventory".
One limitation of the cash based method compared to the accrual system, is that it does not does not take into account the matching principle when preparing accounts. Dissimilarly, the accrual system does use the "matching principle". "The concept of the matching principle is that the cost of an asset should be recognised over the length of time that the asset provides revenue, or benefit, to the business" (Gallagher and Andrew, 2007). This is implying that the "matching principle" enables the sales to be linked with the parallel overhead for the length of time that it is valuable.
Another limitation of the cash based system is that it is not approved by "International Accounting Standard 1". IAS1 which is based on the presentation of financial statements (2012) states, "The minimum requirements for their content and overriding concepts such as going concern, the accrual basis of accounting and the current/non-current distinction". The Cash based system of accounting is inappropriate as it does not comply with IAS. This means that the cash based system cannot be used for international use as they must first be converted using accrual preparation. This may prove to be a problem to some, as converting cash based accounting to accrual based accounting, is difficult and very time consuming to convert to. This is different when it comes to converting accrual system to cash system as it is much easier.
In conclusion, the Cash based system enables transactions to be recorded only when cash is changing hands. This makes the financial statements easier to produce and demonstrate a good idea of cash flow within the company. However, this system does not give a clear idea of the financial position of the business as it leaves items of the balance sheet. Additionally, this system is not approved by IAS1, so it will ineligible for international use. While on the other hand, the accruals system only records transactions when they have been earned and realised. This means that financial statements would be more reliable and a good idea of the company's financial position can be given. Nevertheless, because this method is so thorough, it is more complicated and less able business owners may struggle to complete accounts. Meaning a professional may have to be called in to produce the accounts, making it more expensive for the business.
Moreover, the "cash based system" may be the better option for less experienced account writers who are looking to collect an idea of cash flow within the company. While, the "accruals system" may be a better if more detailed financial statements are needed. For example when the financial position of the business needs to be identified or when accounts are being used as evidence to gain finance.