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Cash and Accrual Accounting


There are two principal methods of keeping track of a business's income and expenses: cash basis or accrual basis of accounting.  Under the cash basis, income is counted when cash (or a check) is actually received and expenses are counted when actually paid (Nolo, 2003).  The net profit is simply the excess of cash inflows from revenues over cash outflows for expenses.  While with the accrual method, it measures the performance and position of a company by recognizing economic events regardless of when cash transactions happen (Gieson, 2002).  The calculation for accrual basis net profit is more complicated and determined by subtracting expenses recognized from revenues recognized in the accounting period. 

Gieson (2002) argues that the accrual basis takes into account that a business entity's life will extend into the future in accordance to the Going Concern rule.  So the real test under this basis of accounting is the determination of when revenues are to be recognized, independent of any cash flow.  Therefore, Carol can accrue revenues and defer expenses if Diamond is adopting accrual basis of accounting.

Accrued revenues

Accrued revenue is defined as .revenue for services rendered or for goods delivered, but not yet recorded (Hoggett and Edwards, 1996).  That is, revenue is generated as a result of a business・s performance in an economic exchange (Gieson, 2002).  For example if Diamond enters into a contractual agreement with ABC company, it is entitled to receive or recognize (accrued) that revenue when it completes the performance (service rendered or goods delivered) no matter ABC actually pays or not.  The key date here is the job completion date where the revenue can be recognized.  However, the Matching rule still requires all expenses such as the costs of the services or goods are matched with the revenues that they help to generate.  This recognition is independent of the actual payment.

Defer expenses

A deferral of expense is defined as .a prepaid expense that has been paid for before they are consumed・ (Hoggett and Edward, 1996).  It is often happened in nowadays businesses.  For example, Diamond might have paid the rent for January in advance.  This expense can be realized or recognized (deferred) in January under the accrual basis.  Another example includes insurance premiums paid for protection to be received in the future.  According to Hoggett and Edward (1996), other goods and services that are paid for in advance and are expected to provide benefits beyond the current period are normally recorded as assets at the time of payment.  These expenses can be realized (deferred) to match the revenues they help to generate in the future.

Accrual accounting provides better matching of revenues and expenses than cash accounting.  Therefore, it makes accounting information more relevant and helps investors better assess firm values and operating performance than operating cash flows.  However, it has two limitations.

First of all, accrual accounting shows the flow of business income and debts more accurately, yet it may leave the company in the dark as to what cash reserves are available which could result in a serious cash flow problem.  Hence, the company requires up-to-date cash flow statements timely as a complement.

Secondly, there are often arguments and questions about the usefulness of accrual accounting information.  Kwon (1989) argues that accrual accounting requires subjective judgments on the future effects of events and is therefore subject to management manipulations.  Hung (2001) also supports this view that accrual systems allow managers to opportunistically manipulate accruals.  It is because managers make estimates for the accrual system and are often evaluated and rewarded based on accounting performance measures.  Thus, it is a temptation for managers to manipulate accruals for personal gain and thus cause accounting measures to be less value relevant.

Consequently, although accrual accounting can help Carol to accrue revenue and defer expense with compliance to corporate governance, whether it is ethical or not would still depend on Carol・s moral judgment and manipulation of the information.    Hung (2001) suggests that it is important to consider institutional factors such as shareholder protection when formulating accounting policies related to accruals.


References

Gieson, DE Van (2002), .Cash Basis vs Accrual Basis of Accounting・, Investopedia.Com, [Online, accessed 5 March 2003]
URL: http://investopedia.com/offsite.asp?URL=http://www.hern.hawaii.edu/hern95/pt035/Accounting/LEVEL_1-INDEPENDENT/CASH-ACR.HTM

Hoggett, John and Edwards, Lew (1996), Accounting in Australia, 3rd Edition, Jacaranda Wiley Australia

Hung, Mingyi (2001), .Accounting Standards and Value Relevance of Financial Statements: An International Analysis・, Journal of Accounting and Economics, Volume 30, Issue 3, [Online, accessed 5 March 2003]
URL:http://www.sciencedirect.com

Kwon, Young K (1989), .Accrual Versus Cash-Basis Accounting Method: An Agency-Theoretic Comparison・, Journal of Accounting and Public Policy, [Online, accessed 5 March 2003]
URL:http://www.sciencedirect.com

Nolo (2003), .Cash vs Accrual Accounting・, [Online, accessed 5 March 2003]
URL:http://www.nolo.com/lawcenter/ency/article.cfm/objectID/08E205EE-E8B6-4D25-A2B01C3AC318E291/catID/AD8C149E-B101-4579-9B53EE41BDB38179


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