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Accounting unit 1 – Financial Accounting

SUBJECT: CAPE ACCOUNTING
UNIT: 1 - FINANCIAL ACCUNTING
MODULE: 1- ACCOUNTING THEORY, RECORDING AND CONTROL
SYSTEMS
TOPIC: Accounting Methods

Officially, there are two types of accounting methods, which dictate how the company's
transactions are recorded in the company's financial books: cash-basis accounting and
accrual accounting. The key difference between the two types is how the company
records cash coming into and going out of the business. Within that simple difference
lies a lot of room for error — or manipulation. In fact, many of the major corporations
involved in financial scandals have gotten in trouble because they played games with
the nuts and bolts of their accounting method.

Cash-based accounting recognizes income when money is received. Accrual-based

accounting recognizes income when goods are shipped or services are rendered. Under
the cash method, an expense is recognized when it's paid. Under the accrual method, an
expense is recognized when the business is obligated to pay it.
So, for example, if in a given period you collect little or no receivables and you pay lots
of bills, under the cash-accounting method, you have expense without income — you've
lost money. On the other hand, if you collect a lot of money and don't pay your bills, you
have big income. That's a major distortion of what actually occurred. Accrual-based
accounting doesn't care whether you've collected or paid your bills. Income (received or
not) is matched to an expense (paid or not), resulting in a proper match of revenue, with
the expense generated to produce the revenue. This provides a truer picture of
operations.

Cash-basis accounting

In cash-basis accounting, companies record expenses in financial accounts when the

cash is actually laid out, and they book revenue when they actually hold the cash in their
hot little hands or, more likely, in a bank account. For example, if a painter completed a
project on December 30, 2003, but doesn't get paid for it until the owner inspects it on
January 10, 2004, the painter reports those cash earnings on her 2004 tax report. In
cash-basis accounting, cash earnings include checks, credit-card

receipts, or any other form of revenue from customers.

Smaller companies that haven't formally incorporated and most sole proprietors use
cash-basis accounting because the system is easier for them to use on their own,
meaning they don't have to hire a large accounting staff.

Accrual accounting

If a company uses accrual accounting, it records revenue when the actual transaction is
completed (such as the completion of work specified in a contract agreement between
the company and its customer), not when it receives the cash. That is, the company
records revenue when it earns it, even if the customer hasn't paid yet. For example, a
carpentry contractor who uses accrual accounting records the revenue earned when he
completes the job, even if the customer hasn't paid the final bill yet.
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Accounting unit 1 – Financial Accounting
Expenses are handled in the same way. The company records any expenses when
they're incurred, even if it hasn't paid for the supplies yet. For example, when a
carpenter buys lumber for a job, he may very likely do so on account and not actually lay
out the cash for the lumber until a month or so later when he gets the bill.

All incorporated companies must use accrual accounting according to the generally accepted
accounting principles (GAAP). If you're reading a corporation's financial reports, what you see is
based on accrual accounting.

Why method matters

The accounting method a business uses can have a major impact on the total revenue
the business reports as well as on the expenses that it subtracts from the revenue to get
the bottom line. Here's how:

● Cash-basis accounting: Expenses and revenues aren't carefully matched on a

month-to-month basis. Expenses aren't recognized until the money is actually paid
out, even if the expenses are incurred in previous months, and revenues earned in
previous months aren't recognized until the cash is actually received. However,
cash-basis accounting excels in tracking the actual cash available.
● Accrual accounting: Expenses and revenue are matched, providing a company with
a better idea of how much it's spending to operate each month and how much
profit it's making. Expenses are recorded (or accrued) in the month incurred, even if
the cash isn't paid out until the next month. Revenues are recorded in the month
the project is complete or the product is shipped, even if the company hasn't yet
received the cash from the customer.

The way a company records payment of payroll taxes, for example, differs with these
two methods. In accrual accounting, each month a company sets aside the amount it
expects to pay toward its quarterly tax bills for employee taxes using an accrual (paper
transaction in which no money changes hands, which is called an accrual). The entry
goes into a tax liability account (an account for tracking tax payments that have been
made or must still be made). If the company incurs $1,000 of tax liabilities in March, that
amount is entered in the tax liability account even if it hasn't yet paid out the cash. That
way, the expense is matched to the month it is incurred.

In cash accounting, the company doesn't record the liability until it actually pays the
government the cash. Although the company incurs tax expenses each month, the
company using cash accounting shows a higher profit during two months every quarter
and possibly even shows a loss in the third month when the taxes are paid.

To see how these two methods can result in totally different financial statements,
imagine that a carpenter contracts a job with a total cost to the customer of $2,000. The
carpenter's expected expenses for the supplies, labor, and other necessities are $1,200,
so his expected profit is $800. He contracts the work on December 23, 2004, and
completes the job on December 31, 2004. But he isn't paid until January 3, 2005. The
contractor takes no cash upfront and instead agrees to be paid in full at completion.

If he uses the cash-basis accounting method, because no cash changes hands, the
carpenter doesn't have to report any revenues from this transaction in 2004. But say he
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lays out the cash for his expenses in 2004. In this case, his bottom line is $1,200 less with
no revenue to offset it, and his net profit (the amount of money the company earned,
minus its expenses) for the business in 2004 is lower. This scenario may not necessarily
be a bad thing if he's trying to reduce his tax hit for 2004.

If you're a small-business owner looking to manage your tax bill and you use cash-basis
accounting, you can ask vendors to hold off payments until the beginning of the next year
to reduce your net income, if you want to lower your tax payments for the year.

If the same carpenter uses accrual accounting, his bottom line is different. In this case,
he books his expenses when they're actually incurred. He also records the income when
he completes the job on December 31, 2004, even though he doesn't get the cash
payment until 2005. His net income is increased by this job, and so is his tax hit.

The accrual method of accounting is an accounting principle that is a foundation of

the entire accounting profession. This method is mandated by financial accounting
regulation and is not to be taken lightly. Financial transactions that a business enters
into are recognized as services or products are consumed or rendered rather than when
cash is paid or received.

The accrual method of accounting recognizes revenues when earned and

expenses when incurred, according to accountingcoach.com. The accrual method of
accounting gives a realistic picture of an entity's profitability each period because of the
importance placed upon the matching principle. Both the income statement and
balance sheet are affected when revenues are recognized. The income statement will
have an increase in revenues, while the balance sheet will either have an increase in
cash (if cash sale) or account receivable (credit sale). When expenses are matched with
the applicable revenues, according to accountingcoach.com, the expenses are
presented on the income statement as they expire, in the expense account. The balance
sheet will show a decrease in cash (if cash paid), an increase in Accounts Payable (for
future expense) or a decrease in Prepaid Expenses (if expense is used up or expired.