According to a definition, “Financial statements are significant for a business. They should provide information about the financial position, which is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions.” (Kam, 2000) Meanwhile, they are important to decision makers who use the financial information they provide to evaluate the performances of the firm and themselves.
Thus, inaccurate financial statements may distort the portrayal of financial position and operating results of a business. For this reason, cash basis of accounting, as one of the accounting methods, is argued whether it is accurate and can be used in preparing financial statements or it is imperfect and may mislead the understanding of the financial statements by decision makers. Cash basis of accounting is defective and financial statements prepared on a cash basis of accounting may distort the portrayal of financial position and operating results of a business.
Every organisation aims to maintain its market dominant position as well as to maximise its profitability through a series of activities, so as to remain competitive within framework of the market mechanism and to advance functions. It is necessary for managers to be familiar with the overall performance of the enterprise, in an effort to develop an effective strategic plan for companies’ prosperity and progress. Thus it is essential to identify the capabilities of a company in economic terms, so as to enable first line management to determine the business’s objectives and targets, concerning its operations.
In an effort to examine an organisation in financial terms, so as to provide managers with sufficient information, referring to its economic evolution, certain financial statements have evolved, such as Balance Sheet, Trial Balance, Profit and Loss Account, Ratios and so on. Nowadays, there are two forms of accounting used by business, cash basis of accounting and accrual basis of accounting. The cash basis method of accounting is based on real-time cash flow.
In such method, you report an expense when it is paid and record income when it is received. So, expenses do not appear on the financial statements until they have been paid. With accrual accounting, you record income when it is earned, not when it is paid.
For one business, financial information, especially income and expense, are extremely important. The net income of the business, which can be considered as the differences between income and expense, directly relates to that company’s profit and loss. Therefore, different methods of accounting choosing in preparing financial statements will cause different results on that business’s profit and loss reporting. Moreover, it will cause different further operations based on those different financial information by decision makers. In fact, comparing with the accrual basis method of accounting, the cash basis method of accounting will mislead the financial position of a business.
One example, as J.H.White described in “Excerpt from Shirt-Sleeves Bookkeeping: The Problem with Cash Basis Accounting” (White, J, H, 1996) is that: for some businesses, cash basis accounting systems create a situation that leads to bankruptcy while, at the same time, reports the company is making a profit. Imagine one company has a project that uses several years. Its income is received prior to completion of the job, but its major costs are paid after the job is completed. In other words, the company receives money in a year prior to paying its expenses. Profit is the difference between the money received and the money spent.
The company who uses Cash Basis Accounting System may provide a financial statement that shows profit in the end of the year. To reduce its tax liability, the best effort is to reducing its profit by spending the money.
In fact, this money is the prepayment of the major cost, which has not accrued until the next year. But it is spent on other things and, because there is so much money available, its spending is out of control. When the major bill does arrive in the next year or so, there is little or no money left from the project to pay for it. The only way is to use the money received from new projects to pay the costs of the old ones. If there are many jobs and huge amounts of money flowing through the business, profits appear on the financial statement to be high. And it looks the company have made a great profit. In such situation, the business may slow down and new jobs stop coming.
Therefore, the money stop coming and only thing left is lots of unpaid bills. Under the cash basis method of accounting, the unpaid expenses are not recorded in financial statement. Thus, the financial statement will report that the company has made a profit rather than its bankruptcy.
Financial statements prepared on a cash basis of accounting may not only cause bad effects on operating a business by managers who could be internal users, but also effect on external users, such as investors and creditors. Profitability refers to the ability of the business to earn income. Net income is the most significant measure of profitability. “Investors and creditors have a great interest in evaluating the current and prospective profitability of a business”. (Woelfel, 1994)
So they can get information about the amount of expected returns and the risk of their investments and loans. In a sense, the cash basis method of accounting is failed to present the significant financial information about the level of profitability of a business, even if to present whether the business is profit or loss. All the financial information is recorded while income and expenses does not actually generate.
Indeed, the efficient operation on a business is related to the actual financial position, which is based on that the business actually earns its income. Income is generated as a result of a business’s performance in an economic exchange. That means a business enters into a contractual agreement to exchange a performance for a consideration, which can be considered as cash. When it completes that performance, it is entitled to receive that cash; it has earned it as income. At that time income only can be recognized.
Moreover, there are four types of timing differences in recognizing income and expenses, which may not be distinguished by Cash Basis Accounting. They are:
- Income is recognized before cash is received
- Expense is recognized before cash is paid
- Income is recognized after cash is received
- Expense is recognized after cash is paid (Kam, 2000)
The importance of control programs and effective internal control techniques are made clear in the business conduct guide for Target and in Wal-Mart’s proxy statement. Wal-Mart gives specific guidelines of an eligible person who can be part of the auditing committee according the New York Stock Exchange Definitions. The duties of the auditing committee are also outlined. Wal-Mart has implemented the strategy of segregation of duties which separates the responsibilities of account keeping amongst different departments in different phases (Albrecht et al, 2005).
Target also uses an auditing committee and a segregation of duties (Albrecht et al, 2005). Target describes the importance of maintaining accurate books, records and accounts in order to ensure accounting objectives are met and the financial integrity of the company is upheld. Target discusses in the business conduct guide their commitment to comply with all laws and regulations. Target promises to give accurate reports to the Securities and Exchange Commission and to the New York Stock Exchange.
Sarbanes-Oxley Act The 2002 Sarbanes-Oxley Act requires, among other things, that every company’s annual report contain an “internal control report,” which must state the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting and contain an assessment of the effectiveness of the internal control structure. In the wake of illegal political campaign contributions, business frauds, and numerous illegal payments to foreign officials in exchange for business favors. These acts were needed because of companies falsifying records and were not accurate financial records. (Gaffikin, 2002)
The main point of the income statement according to Weygandt & Kieso, (2005) is to report the profitability or loss of the business during a specific period of time. On the income statements the revenues are listed first. After the revenues the expenses are listed. The income statement is useful to managers because this tool allows the managers to see whether the business was profitable or not. The income statement is also useful to investors. Through the income statement, the investors can observe if the investment is a profitable one.
The financial statements are useful to both internal users and external users. The internal users according to Weygandt & Kieso (2005) are the managers who not only plan a business but also organize and run the business. In order to have a successful business, a manager needs to have answers to questions. In order to have the answers, the managers must resort to the financial statements. The financial statements will provide the necessary information, which could be used for future financial projections. The external users as Weygandt & Kieso (2005) state are investors or owners and creditors.
The investors use the financial statements in order to decide whether to buy, hold or sell the stock. The creditors which include the suppliers and lenders use the financial information found in the financial statements to evaluate all the risks involved in lending the company money or granting the company credit.
Gaffikin, M, 2002, Principles of Accounting 2002 Edition, Pearson Education Australia, Australia.
Kam, 2000, Accounting Theory, Second Edition, John Wiley $ Sons, New York.
White, J, H, 1996, Mind & Money, Seattle, WA.
Woelfel, C, J, 1994, Financial Statement Analysis: The Investor Self-Study Guide to Interpreting & Analyzing Financial Statements, Revised Edition, Probus Publishing Company, Canada.
Albrecht, W. S., Stice, J. D., & Swain, M. R. (2005). Accounting: Concepts and Applications. In Chapter 6: Ensuring the Integrity of Financial Information. South-Western.
Weygandt, J., Kieso, D., and Kimmel, P. (2005). Financial Accounting (5th ed.). Hoboken. NJ: John Wiley & Sons, Inc. 22-25, 110-14.