vs. Cash Accrual by Narinder Schoeling
Cash vs. Accrual: Is there a difference in recognizing transactions
Narinder Schoeling
Ashford University Online Campus
ACC 206
Principles of Accounting II
Professor Emily King's
May 15, 2009
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Abstract
In this paper, I will reflect on Accounting concepts and principles that accountants
have used to guide their work within the company. I learned a lot from this course and I will use
that to help write this paper. In the following paper I will discuss my ideas on how the functions
of accrual accounting verses cash basis account work within a company and witch increase the
effectiveness and contribution to the organization of the businesses books and cash flow to reach
the final objective. I will also discuss the impact of the accounting period has on a business. This
will be done through identifying the functions the revenue principle and the matching principle.
I will explain how to record transaction on the books. Also last I will discuss how these aspects
work together to perform that primary functions of accounting. All of this will be discussed in
depth in the following paper.
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Cash vs. Accrual: Is there a difference in recognizing transactions
I will use what I have learned in this course to show how companys uses the accounting
process within a company. How corporations use accrual accounting verses cash basis
accounting contributes to an organization. How corporations use accounting to update the
accounts using a process called adjusting the books. I will also discuss the impact of adjusting
the books it requires special journal eateries. I will also discuss the impact of the accounting
period on a business. This will be done through identifying the functions the revenue principle
and the matching principle. I will explain how record transaction on the books. Also last I will
discuss how these aspects work together to perform that primary functions of accounting.
Cash vs. Accrual
Every business must decide witch method to use the cash or accrual accounting. The
difference between the two accounting processes is in how cash transactions are record. Cash
and accrual accounting are similar in their methods of maintaining accurate accounting records.
While they share many aspects in common, there are two differences between cash and accrual
accounting is in the way debits and credits are applied in the bookkeeping process. To
understand the difference, we must first define each type.
Cash-based accounting Method
Cash-basis accounting, records only cash receipts and cash payments. Allows for the
r ecognition of income at the t ime it is actually received. I t ignores the account receivables,
account payables, and depreciation and only records cash receipts and cash payments
( Horngren, C. T. & Har r ison W. T., 2007). Cash-based accounting recognizes income when
money is received.
This means that invoiced income is not counted as an asset until
payment for the invoice is actually in hand.
The same approach is applied to debits, in
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that any expenses incurred are not posted until they are paid. Cash receipts are t reated as
revenues and cash payments are t reated as expenses.
In cash-basis accounting, a ll t ransactions are recorded in the books when cash
actually changes hands. This meaning that only when cash payment is received by the
company from customers or paid out by the company for purchases or other services are
t hey recorded onto the ledger. Cash receipt or payment can be in the form of cash, check,
credit card, electronic t ransfer, or other means used to pay for an i tem only (Score
Counselors to Americas Small Business, 2005).
Cash-basis accounting can't be used if a store sells products on store credit and bills the
customer at a later date.
There is no provision to record and track money due from customers at
some time in the future in the cash-basis accounting method. That's also true for purchases. With
the cash-basis accounting method, the owner only records the purchase of supplies or goods that
will later be sold when he actually pays cash.
If he buys goods on credit to be paid later, he
doesn't record the transaction until the cash is actually paid out (Score Counselors to Americas
Small Business, 2005).
Depending on the size of the business, most start out with cash-basis accounting. Many
small businesses use cash-basis accounting because it's easy. When a business grows it
necessary to switch to accrual accounting in order to more accurately track revenues and
expenses.
Cash-basis accounting does a good job of tracking cash flow, but it does a poor job of
matching revenues earned with money laid out for expenses. An example of cash-based
accounting is if a product is bought in June for $1,000 cash but not sold until July, and when the
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books are closed at the end of June there will be no revenue to offset it, which means that there
will be a loss for that month. And also when the products are sold for $1,500 in July then a
profit of a $1,500 will be shown for July, but when the actual profit of revenues is only $500
(Wisegeek, 2009). So this is a drawback of cash accounting method.
Accrual Accounting Method
Accrual accounting how ever does recognize income at the time it is earned. But as
goods or services are invoiced, the invoices are posted and counted as assets. They remain
i n this state until it is credited by a payment. The other is that all expenses are also posted
a t the t ime they are incurred or invoiced for those expenses is received, and remains open
u ntil the expenses are paid.
Accrual accounting, records all transactions onto the ledger when it occurs, even if no
cash changes hands.
For example, if items are sold on store credit, it is recorded as a
transactions immediately and is entered into an Accounts Receivable account until payments is
received.
But if goods are bought on credit, it is also recorded immediately by entering it as a
transaction into an Accounts Payable account until cash is paid (Wisegeek, 2009).
Accrual accounting also has its drawbacks.
expenses, but it does a poor job of tracking cash.
It does a good job of matching revenues and
That is because revenue is recorded when the
transaction occurs and not when cash is collect, income statement can look great even if there is
no cash in the bank. For example, record the revenue upon completion of the job even if the
cash haven't yet been collected.
of revenue but little cash.
If customers are slow to pay, a company may end up with lots
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Most mid-level and large businesses today tend to rely on the use of the accrual
account method rather than cash-basis accounting method. Doing so allows a business to
determine at a glance how much cash is in hand, how much is currently pending in
outstanding invoices, and what current expenses are awaiting payment.
At the same t ime,
m any individuals tend to go with a cash-basis accounting approach for the home budgeting,
t ending to post income as it is received and posting payments for expenses when they are
actually sent out (Score Counselors to Americas Small Business, 2005).
Many companies that use the accrual accounting method monitor cash flow on a weekly
basis to be sure they have enough cash on hand to operate the business.
If the business is
seasonal, such as a landscaping business with little to do during the winter months, they have to
establish short-term lines of credit through the bank to maintain cash flow through the lean times
(Wisegeek, 2009).
Under the accrual method, an expense is recognized when the business is obligated to pay
it. Accrual-based accounting doesn't care whether cash is collected or bills are paid.
Income is
matched to an expense, resulting in a proper match of revenue, with the expense generated to
produce the revenue. This provides a truer picture of operations (Wisegeek, 2009).
The Accounting Period
The second accounting concept that helps guide accountants is the accounting period.
Accountants slice time into small and segments prepare financial statements for specific periods.
This is called an accounting period. The basic accounting period is one year, and all businesses
prepare annual financial statements. This usually runs the calendar year from January 1 to
December 31. However some companies use a fiscal year. This is the year-end and is usually
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the low point in businesss activity for the year. Companies also prepare financial statement for
interim periods, such as monthly, quarterly, and semiannually. Accounting period is the period
for which a business prepares its accounts. Internally, management accounts may be produced
monthly or quarterly.
Externally, financial accounts are produced for a period of 12 months,
although this may vary when a business is set up or when it changes its accounting year end
(Horngren, C. T. & Harrison W. T., 2007).
Even if all transactions during the year have been recorded correctly, the business's accounts
still aren't quite ready for preparing the financial statements.
Additional procedures are
necessary at the end of the period to bring the accounts up to snuff for preparing financial
statements for the period.
Two main things have to be done at the end of the period:
The first one is to record normal, routine adjusting entries. Is when a company may not have
associated certain expenses and income with a specific transaction, and, therefore, they didn't
record those expenses and income. Well, this is when they are recorded. For example,
depreciation expense isn't a transaction as such and therefore isn't included in the flow of
transactions recorded in the day-to-day bookkeeping process.
You need to make these kinds of
adjustments to have current balances for determining profit for the period, and making the
revenue, income, expense, and the loss accounts up-to-date and current for the year.
The second is to check for developments that may affect the accuracy of accounts. For
example, the company may have discontinued a product line.
They may have removed the
remaining inventory of these products from the asset account, with a corresponding loss recorded
in the period.
Layoffs and severance packages are another example of what may need to be
looked for before preparing reports (Score Counselors to Americas Small Business, 2005).
The Revenue Principle
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The Revenue recognition p rinciple is a cornerstone of accrual accounting together
w ith matching principle. They both determine the accounting period, in which revenues
and expenses are recognized.
According to the principle, revenues are recognized when
t hey are realized or realizable, and are earned no matter when cash is received.
Revenues are realized when cash or claims to cash (receivable) are received in
exchange for goods or services. Revenues are realizable when assets received in such
exchange are readily convertible to cash or claim to cash. Revenues are earned when such
goods or services are t ransferred or rendered.
Both, such payment assurance and final
delivery completion are required, because of revenue recognition.
Recognition of revenue from four types of t ransactions:
1. Revenues from selling inventory are recognized at the date of sale often interpreted
as the date of delivery.
2. Revenues from rendering services are recognized, when services are completed and
b illed.
3. Revenue from permission to use companys assets like interests for using money, rent
for using fixed assets, and royalties for using intangible assets are recognized as
t ime passes or as assets are used.
4. Revenue from selling an asset other than inventory is recognized at the point of sale,
w hen it takes place.
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In practice, this means that revenue is recognized when an invoice has been sent. T he
revenue principle tells accountants when to record revenue that is, when to make a journal
entry for a revenue and the amount of revenue to record (Revenue recognition, 2008).
T he revenue principle tells accountants the criteria that are generally accepted by the
U nited States. T he U.S. Securities and Exchange Commission's SAB101 states that
revenue generally is realized and earned when a ll of the following criteria are met:
1. Persuasive evidence of an arrangement exists.
2. Delivery has occurred or services have been rendered.
3. The seller's price to the buyer is fixed or determinable.
4. Collectabili ty is reasonably assured (Revenue Recognition, 2008).
Matching Principle
The matching principle guides accounting for expenses. The expenses such as salaries,
rent, utilities, and advertising are assets used up and liabilities created in order to earn revenue.
The matching principle directs accountants to: measure all the expenses incurred during the
period. Match the expenses against the revenues of the period (Horngren, C. T. & Harrison W.
T. (2007).
Matching principle Expenses have to be matched with revenues as long as it is reasonable
to do so. Expenses are recognized not when the work is performed, or when a product is
produced, but when the work or the product actually makes its contribution to revenue. Only if
no connection with revenue can be established, may cost be charged as expenses to the current
period (e.g. office salaries and other administrative expenses). This principle allows greater
evaluation of actual profitability and performance (shows how much was spent to earn revenue).
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Depreciation and Cost of Goods Sold are good examples of application of this principle
(Revenue Recognition, 2008).
The Time Period Concept
This concept deals with the fact that the owner needs a periodic reading on their business.
The time period concept ensures that the information is reported often. To measure income,
companies update their accounts at the end of each period. And it assigns the salary expenses to
April because that was the month when they worked for the company (Horngren, C. T. &
Harrison W. T., 2007). Accounting concept that the operating cycle of a firm can be divided
into distinct accounting periods (a month or a quarter, for example) of relatively short lengths for
which accounting information can be collected, matched, and reported in a timely manner (Time
period concept (2009).
Conclusion
I have learned through this research paper the importance of understanding the basic
concept of accounting in order to understand the rest of accounting; I will be able to use
w hat I have learned in this course to show the accounting process within a company. I
have realized the importance of knowing the revenue recognition p rinciple and along with
t he matching principle determine the accounting period, in which revenues and expenses
a re recognized. This is done through a t ime period concept to inform the owner how the
company is profiting. I have realized through this research paper has shown me the indepth pursuers that a corporations uses in accounting to update the accounts and adjust
t he books. I have learned that in order to be successful in managing accounts that I need
Cash vs. Accrual by Narinder Schoeling
to make sure that all t ransactions are posted correctly and use a interim period such as
monthly to make the company runs effectively.
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References
Horngren, C. T. & Harrison W. T. (2007). Accounting (7th Ed.). Upper Saddle River, New
Jersey: Pearson Prentice Hall.
Revenue recognition (2008). From Wikipedia, the free encyclopedia online. Retrieved May 15,
2009 from, http://en.wikipedia.org/wiki/Revenue_recognition.
Score Counselors to Americas Small Business (2005).Cash vs. Accrual Accounting Methods.
Retrieved on May 15, 2009 from, http://www.score.org/fc_13.html.
Time period concept (2009). From Business Dictionary online. Retrieved on May 15, 2009 from,
http://www.businessdictionary.com/definition/time-period-concept.html
Wisegeek (2009). What is the Difference between Cash Accounting and Accrual Accounting?
Retrieved on May 15, 2009 from, http://www.wisegeek.com/what-is-the-differencebetween-cash-accounting-and-accrual-accounting.htm