Non-accountants are likely to calculate profits using cash accounting system; under the system, profit is calculate as the difference between cash receipts and cash payments; however, International Financial reporting standards (IFRS) require firms to prepare financial reports using the accrual accounting method. Under accrual method of accounting, expenses and revenue are matched with the period they were incurred or earned (Horngren, 2007). This paper differentiates cash and accrual methods of accounting; it will also look into their advantages and disadvantages.
When using cash accounting method, the profits are calculated as the difference between the cash collected and the expenses that has been paid for.
- Profits = realized revenue – paid expenses
Expenses are daily expenditure that a business incurs in course of doing business. When using cash accounting system expenses are recognised as incurred when they have been paid for. For example if a company in the month of January 2010 had not paid its December 2009 salary, and it does so in January, then the expense will be reflected as an expense incurred in the year 2010.
Sales are the turnover of a business. It may be in cash or credit basis. When a business is recording its expenses using cash basis, a sale made in a certain period for cash will be accounted for in that period but a sale made in credit will be accounted for when proceeds from the sales have been received from the debtor. Cash accounting is common in small business however; international accounting standards recognise accrual method as the basis of accounting. Depending with the size and kind of a business that one is operating, a choice of either method is important (Horngren, 2007).
Advantages of cash basis of accounting
- Cash is realised on real-time cash flow basis; the method does not have to relate an expense or an income to a certain period but recognises it when it has actually been realised.
- When using the method, it is possible to delay taxable income to a future period and thus it helps in tax planning.
- When using the method, it is easy to accelerate expenses when they are paid when revenue is available. This helps in real time management.
- It is a straight forward accounting method that is easy to adopt; this makes the method be common in small-scale businesses and to non-accountants (Horngren, 2007).
Disadvantages of cash basis of accounting
- The method does not support matching concept where revenue and expenses should relate to a certain period that they were earned or incurred in.
- The method can be manipulated to benefit a certain party and thus violates the integrity of financial accounts.
The concept is not supported by international accounting standards; this reports using the method cannot be reported as true and fair (Weygand, Kimmel & Kieso, 2010).
Accrual accounting method
Accrual method uses the matching concept approach; under the method, income and expenses are recognised when they have been incurred or earned and thus they relate to the period that they were earned or incurred (Weygand, Kimmel & Kieso, 2010). When using method, the companies profit is calculated as the difference between the sales related to a certain period less the expenses incurred in the period (expenses relating to the period).
Advantages of accrual accounting method
- The method uses a matching concept where income and expenditure are matched with the period that they were attained. This economical approach gives true financial standing of a business.
- International accounting bodies support the method. It gives the true picture of the business and thus makes financial statements more useful to their users.
- Manipulation of accounts made in accrual system is difficult. This is so because revenue and expenses are matched to the period that they relate (Weygand, Kimmel & Kieso, 2010).
Disadvantages of accrual accounting method
- The system is costly to implement in a business. This is because it is not a straightforward method especially for non-accountants.
- The system may recognise some revenue that will not be collected in the future; this is so because the method recognises that revenue having been earned even before the amount has been received (Weygand, Kimmel & Kieso, 2010).
Examples how accrual method can be used to manipulate profits
Let us take hypothetical case of a company with the following accounting information:
- Sales 1,000
- Purchases 500
- Paid salaries 100
- Unpaid salaries 200
The profit of the company using accrual method is:
- 1000 – 500 – (100 + 200) = 200
When using cash method the profit is:
- 1000 – 500 -100 = 400
The above example shows how accrual method can be used to report lower profits.
Using the above example, but this time with an payment advance payment of 50 in salaries, then Using the accrual method, profit is:
- 1000 – 500 – (100+200-300) = 500
When using the cash method then:
- 1000-500- (400) = 100
The above example illustrates how accrual method can be used to report higher profits than they were incurred.
Horngren, H., 2007. Accounting Edition 7e. New Jersey Prentice Hall.
Weygand, J., Kimmel, P. and Kieso, A., 2010. Financial Accounting: IFRS. Illinois: Northern Illinois University