Accounting methods

Cash basis

Cash-basis accounting is a method of bookkeeping that records financial events based on cash flows and cash position. Revenue is recognized when cash is received and expense is recognized when cash is paid. In cash-basis accounting, revenues and expenses are also called cash receipts and cash payments.

Cash-basis accounting does not recognize promises to pay or expectations to receive money or service in the future, such as payables, receivables, and prepaid or accrued expenses.

This is simpler for individuals and organizations that do not have significant amounts of these transactions, or when the time lag between the initiation of the transaction and the cash flow is very short.

Two types of cash-basis accounting exist: "strict" and "modified". Strict cash-basis follows the cash flow exactly. Modified cash-basis includes some elements from accrual-basis accounting such as inventory and property capitalization.

Issues with cash basis

Cash-basis accounting is generally not acceptable for entities that must make their financial statements publicly available. This is because most countries require companies to comply with the accruals basis of accounting. Cash-basis accounting is not considered to provide a true and fair view of the financial performance and position of an entity under IFRS [IASB International Accounting Standard 1, paragraph 8] .

Additionally, cash-basis accounting is not viable for cost accounting in manufacturing operations because expenses cannot always be correctly associated with product costs.

Accrual-basis accounting"'

Accrual-basis accounting (a.k.a. accrual accounting) records financial events based on economic activity rather than financial activity. Under accrual accounting, revenue is recorded when it is earned and realized, regardless of when actual payment is received. Similarly, expenses are “matched” (a process known as matching or expense matching) regardless of when they are actually paid. Accrual accounting is required by US GAAP (Generally Accepted Accounting Principles), IFRS (International Financial Reporting Standards), and legislation such as the UK’s Companies Act 1985.

Comparison

* Using cash-basis accounting, income and expenses are recognized only when cash is received or paid out.
* Using accrual-basis accounting, receivables and payables are recognized when a sale is agreed to, even though no cash has been received or paid out as yet.
* Cash-basis accounting defers all credit transactions to a later date. It is more conservative for the seller in that it does not record revenue until cash receipt. In a growing company, this results in a lower income compared to accrual-basis accounting.

A simple example

* A small business such as a fruit stand, which buys its inventory daily for cash at a wholesale market, sells the inventory for cash, and throws away what didn't sell, can get an accurate picture of its profits or losses using cash-basis accounting.
* A remodeling business that gives customers 90 days to pay and that procures materials on account at the lumber yard, must use the accrual method to gain an accurate picture of its financial condition.
* Either business will probably get a relatively accurate picture using either method over a long period of time, except for the transactions that have already begun that are not yet closed.

Other considerations

Standard accrual-basis financial statements (income statements and balance sheets) do not indicate the cash inflows and outflows of a company. The cash flow statement is created to indicate that information for accrual-basis accounting.

Accrual-basis accounting is more costly to maintain, because it requires the bookkeeper to record many more transactions. However, the advent of accounting software has made the difference between the reporting methods less significant.

Companies that have extended or used credit significantly should use (and in the United States may be required by the Internal Revenue Service to use) the accrual-basis method of accounting. The U.S. Securities and Exchange Commission requires that all publicly traded companies follow GAAP, thus all publicly traded companies publish their financial statements using accrual-basis method.

For tax purposes, cash basis accounting is highly favored because it defers tax burdens until the cash is received and provides for automatic bad debt relief as revenue (and therefore profit) is not recorded until cash is received from the debtor. It is often used by small businesses and organizations that are not required to use the accrual method, both for tax reasons and for its simplicity.

References

External links

* [http://blog-pfm.imf.org/ The IMF Public Financial Management Blog]