Question

I do not understand this question could someone please answer and give meaning to this question. MHC6305 Finanical Management.

Compare and contrast cash accounting methodology and accrual accounting methodology in order to illustrate how each best works for different types of companies.

Answer 1

CASH BASIS OF ACCOUNTING

1. Revenues are recorded in the income statement when cash is received from customers (inflow of cash)

Expenses are recorded on the income statement when cash is paid to suppliers and employees. ( Outflow of cash)

2. In cash basis account receivable and payable are not recognised.

3. Less used by the companies.

4. Simple to understand. (It's easy to determine when a transaction has occured because when cash is received or cash is paid we say that the transaction has occured )

5.By seeing cash it might seem that company is cash rich but it might have large amount of account payable that far exceed the cash on the books.(This is disadvantage of cashflow)

6. Small cash based business, sole proprietor, etc use the cash basis of accounting because it is simple to understand and implemention.

ACCRUAL BASIS OF ACCOUNTING

1. Revenues are recorded on the income statements when they are earned ( regardless of when the money is received.)

Expenses are recorded on the income statements when they are incurred i.e. billed ( regardless of when the money is paid)

2. In Accrual basis account receivable and payable are recognised and as a result more accurate picture of the profitability of company.

3.More commonly used by the Companies .

4.Complicated than cash basis since it records the income and expenses when they are earned and billed respectively.(irrespective of cash inflow or outflow.) The transaction occurs only when income is earned or expenses incurred.

5.Accrual basis gives more realistic idea of income and expenses during a period of time generally in the long run.

6. Tracking cashflow is difficult with accrual basis so might not know of cash shortage of company.

7. Publicly traded companies and large companies use accrual method of accounting to show more accurate picture of profitability of the company which cash basis of accounting cannot show.

8.The companies which has to comply with US GAAP follow accrual basis of accounting.However for public sector entities such as national, regional , local govenments and related governmental agencies can follow cash basis of accounting.

9 According to Internal revenue service website if you operate as a sole proprietorship or small business, especially a service-related business that does not carry inventory, you'll be able to use cash accounting as long as your gross annual revenue does not exceed $1 million. Otherwise, you must use accrual accounting. If your company is a partnership or a C-corporation, with average gross revenue exceeding $5 million per year, you must also use accrual-basis accounting. If you offer any credit to your customers and let them pay you later for the purchases, or

if your business makes any purchases on credit, you must use accrual accounting. If you manufacture a product, buy goods for resale, sell merchandise or report any inventory that your business has on hand at the end of each year for taxes, the IRS requires you to use accrual accounting.

EXAMPLES OF CASH BASIS AND ACCRUAL BASIS OF ACCOUNTING

REVENUE RECOGNITION

A seller sells one calculator for $15 to a customer in January,which pays the invoice in February.Under cash basis, the seller recognizes the sale in February when the cash is received.Under the accrual basis the seller recognizes the sale in January when it issues the invoice.

EXPENSE RECOGNITION.

A buyer buys $ 1000 office supplies in June , which it pays in July .Under the cash basis the buyer recognizes purchase in July when it pays bill. But under the accrual basis the buyer recognizes the purchase in June when it receives the suppliers invoice.