Question

Statement of Financial Accounting Concepts No. 1 states that one of the objectives of financial reporting is to help “current and potential investors and creditors (and other users) in assessing the amounts, timing, and uncertainty of future cash flows such as dividends or interest payments.” Generally Accepted Accounting Principles (GAAP) require the use of the accrual basis of accounting. Explain the difference between the accrual basis and the cash basis of accounting and why GAAP requires the accrual basis.

Please include a scholarly reference.

Answer 1

It assumes that investors and creditors are interested in cash-flow information when evaluating investment opportunities. Accrual information helps investors estimate future net cash flows and the risks associated with these flows. The accrual basis is required under Generally Accepted Accounting Principles (GAAP).

Accrual basis accounting requires that an event that alters the economic status of a firm as represented in the firm’s financial statements be recognized in the period in which the event occurs rather than when cash is exchanged. The accrual basis focuses on transactions and related events with cash consequences. Under the accrual basis, revenues are recorded when they are earned and expenses when they are incurred. Recognition of expenses or revenues in the accounting records under the accrual basis often occurs before or after the payment or receipt of cash.

The earnings figure resulting from application of the accrual basis reflects changes in financial position rather than immediate cash consequences. Accrual basis earnings more fully reflect the resource changes affecting the firm’s net assets for a period than does the cash basis. Financial statement users find earnings information valuable because profits determine the long-run success of a company. Accrual measures, including financial statement ratios, have been found by researchers to be more accurate predictors of business failure. Companies with poor operating cash flows can survive for extended periods of time if creditors are willing to renegotiate and restructure debt. Companies that are growing rapidly may have negative cash flows because these companies may need to invest heavily in capital expenditures.

Adjusting journal entries are required under the accrual basis to ensure that revenues are recorded when earned and expenses are recorded when incurred. For example, an adjusting journal entry records interest expense before cash is paid since the passage of time results in the obligation to ultimately pay interest.

A cash basis accounting system reports only the receipt and disbursement of cash. Cash basis accounting requires few, if any adjusting entries. Cash information is far from useless, however.

In the short run, cash flow information is most important since it indicates whether a borrower will produce sufficient cash to pay its liabilities. Creditors are interested in a company’s past and future ability to generate positive cash flows.

Research has found that cash flow information increases the overall information content of financial statements. Cash flow information also has been shown to supply risk assessment information beyond that provided by accrual basis earnings information. For example, a company with a strong working capital position but with large amounts of inventories, prepaid expenses, and receivables might be in a weak cash position.

The increasing complexity of financial accounting principles and the increasing complexity of financial statements as a result of applying these principles has increased the demand by financial statement users for cash flow information. Under current accrual basis accounting principles, managers also have flexibility to choose among several reporting choices thus allowing the manipulation of earnings under current GAAP.

The prevailing view currently is that neither cash flow nor accrual basis information alone is sufficient for a complete understanding of a company’s performance. The relationships between revenues and cash inflows and between expenses and cash outflows can be understood only by studying both types of information.