Understanding Financial Reporting
The financial reporting refers to the process of presenting the financial 9information about the company in a systematic manner (Flowers & Ebbers, 2018). The financial reports of the organization contain information regarding the financial activities of the business. Primarily, the financial reporting is an accounting function. The financial reports are prepared for the purpose of informing the stakeholders regarding the transactions carried out by the entity during a particular accounting period (Roychowdhury, Shroff & Verdi, 2019). Stakeholders refers to those individuals or group that have an interest in the operation and functioning of the enterprise. The stakeholders of the organization are also known as the users of financial information. The users of financial information are internal as well as external. The internal users include the management and the employees whereas the external users comprise of present and prospective shareholders, customers, suppliers, lenders, government authorities and the financial analysts. All public entities are required to prepare the financial statements and disclose it to the users so that they can take their economic decisions. The financial statements disclosed by the company include the statement of profit and loss, balance sheet, cash flow statement and the statement of comprehensive income (Amiram, et al., 2018). The financial transactions of the companies are recorded using cash or accrual basis. This report contains information regarding the cash and accrual basis of accounting.
Cash basis of accounting refers to the method of accounting in which the company recognizes the expenses and revenue at the time of receipt and payment of cash (Turini, Septian & Lestari, 2021). In such system of accounting, a transaction only gets recorded when the cash is exchanged from one party to another. It is the simplest form of accounting and is mostly used by the small businesses and individuals (Javed & Zhuquan, 2018). This form of accounting involves recording of transaction only when the cash is received or paid. It is also known as cash accounting. Under this type of accounting, income from credit accounts are not considered. It is only used by small businesses and individuals which deals in cash. The public entities are not allowed to record the financial transactions using the cash basis of accounting under the International Financial Reporting Standards and Generally Accepted Accounting Principles.
It violates the matching principle of GAAP and is best suited for non-profit organizations, individuals, and service-based entities (Ovsyuk & Burdeina, 2021). The balance sheet does not show the accurate financial position of the company. Cash basis accounting can be preferred by organizations such as community association, non-profit organizations, government agencies and small service businesses which do not deal in inventory.
The organizations that follow the cash basis of accounting does not record transactions that are carried out on credit. Cash accounting uses single-entry accounting instead of double-entry accounting. Small businesses are not required to publish the financial statement like public entities. Goods and services are not delivered to the customers on credit. The IRS requires having inventory are required to follow the accrual basis of accounting. However, there are certain exceptions when businesses with inventory can use cash accounting.
Cash Basis of Accounting
If the entity follows the cash basis of accounting for recording the transaction, tracking of purchases and sales would be difficult as it would lead to huge gaps between the reported revenues and expenses and the inventory accounting. It is for this reason that the businesses uses accrual basis of accounting. The primary reason for choosing the cash basis is its simplicity and the ease of use. If the owner does not have detailed knowledge about the accountant, they can adopt cash basis of accounting for transactions.
The use of cash basis of accounting has several disadvantages such as it does not show the inaccurate picture of the business performance during the accounting period. It is because the expenses of the current year may be charged to the next year when the payment is actually made. Some of the reasons why the business adopts cash accounting system are as follows:
- The company does not have large number of employees.
- The company uses cash, check, debit or credit card for carrying out transactions.
- The company does not have inventory to track.
The use of cash accounting provides several advantages such as ease of use, less expensive, exists in the present, and the potential tax advantage. It offers a straightforward and simple approach to record the financial transactions (Asuquo & Udoayang, 2020). The company that follows cash accounting method does not require hiring of accountants, and thus reducing expenses of the firm.
The accrual basis of accounting is followed by corporate financial reports. Under this type of accounting, the revenues and expenses are recorded as and when accrued (Bruno & Lapsley, 2018). It ignores the time of receipt and payment of cash. The transactions are recorded in the financial statements for the periods in which they relate, irrespective of the payment of cash. It is different from the cash basis as the transactions are recorded as and when it occurs. This method of accounting follows the matching principle, which says that all revenues and expenses should be recognized in the period in which it occurs. All the credit transactions are recorded under accrual basis of accounting.
The accrual accounting system recognizes the expenses when it is incurred and revenue when it is earned whereas the cash accounting reflects the business transaction when the cash flows out or into the business. The recording of transactions under the accrual accounting system requires the estimation of figures in certain areas. The use of this approach has an impact on the balance sheet as the payables and receivables are recorded even if the cash is received or not.
One of the main reasons between the cash basis and accrual basis of accounting is that the former method of accounting may yield inaccurate results whereas the latter enables the entity to record all transaction that takes place during a particular period. It supports the matching principle in which the expenses and revenues are recorded within the same period in which it occurs (Azhars, et al., 2021).
The accrual basis of accounting is often used by large entities to record the financial transactions (Bergmann, Fuchs & Schuler, 2019). The accrual method focuses on the anticipated expenses and revenue whereas the cash method is a more immediate recognition of expenses and revenue. It is easy to prepare the financial statement using cash method than the accrual method. The main disadvantage of the cash method is that it might reflect inaccurate picture of the company. It may be possible that the company may be losing money in actual when the statement are disclosing profits.
The accrual basis of accounting gives the accurate picture of the company’s profitability, while including the accounts payables and receivable.
Conclusion
From the above the discussion, it becomes clear that accrual basis is followed by large entities that carry out its transactions on credit. All public entities are required to record the financial transactions using the accrual accounting because cash method accounting does not follow the GAAP or IFRS. It is preferred choice for companies that deal mostly in credit and large number of transactions on a daily basis. Accrual basis of accounting was adopted due to the need of more accurate financial information and the increasing complexity in financial transactions. The accrual accounting is more reliable than the cash accounting as it provides more accurate picture of the company’s position. The accrual accounting allows auditing of the financial transactions recorded in the financial statements. However, the recording of transactions using the accrual basis requires deep knowledge about accounting concepts and conventions. Overall, accrual basis are used by large businesses that deals on credit whereas the cash basis is used by the entities who do not have inventory and are usually small.
References
Amiram, D., Bozanic, Z., Cox, J. D., Dupont, Q., Karpoff, J. M., & Sloan, R. (2018). Financial reporting fraud and other forms of misconduct: a multidisciplinary review of the literature. Review of Accounting Studies, 23(2), 732-783.
Asuquo, A. I., & Udoayang, J. O. (2020). Effect of Accounting Practices on trade and Information technology in Calabar Metropolis. International Journal of Recent Technology and Engineering, 8(6), 1572-1577.
Azhar, Z., Alfan, E., Kishan, K., & Assanah, N. H. (2021). Accrual Accounting at Different Levels of the Public Sector: A Systematic Literature Review. Australian Accounting Review.
Bergmann, A., Fuchs, S., & Schuler, C. (2019). A theoretical basis for public sector accrual accounting research: current state and perspectives. Public Money & Management, 39(8), 560-570.
Bruno, A., & Lapsley, I. (2018). The emergence of an accounting practice: The fabrication of a government accrual accounting system. Accounting, Auditing & Accountability Journal.
Flower, J., & Ebbers, G. (2018). Global financial reporting. Macmillan International Higher Education.
Javed, M., & Zhuquan, W. (2018). Analysis of accounting reforms in the public sector of Pakistan and adoption of cash basis IPSAS. Universal Journal of Accounting and Finance, 6(2), 47-53.
Ovsyuk, N. V., & Burdeina, Y. I. (2021). Features of cash accounting at the enterprise.
Roychowdhury, S., Shroff, N., & Verdi, R. S. (2019). The effects of financial reporting and disclosure on corporate investment: A review. Journal of Accounting and Economics, 68(2-3), 101246.
Turini, T., Septian, W. E., & Lestari, W. J. (2021). Accounting information system for spare parts cash sales using the cash basis method at the vie jaya motor workshop cirebon. In Global Conference on Business and Management Proceedings (Vol. 1, No. 1, pp. 85-95).
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