In every business, some transactions are recognised and recorded that relate to revenue. There are two different accounting system methods available that relate to the recording of transactions which is known as cash system accounting and accrual system of accounting. The only difference between the two methods is the bookkeeping entry which is timing. The accrual system of accounting requires recording of all transactions when they occur or become due, and the cash accounting system is a simplified method that records the income and expense immediately as it arises. For example, let us say you are a self-employed electrician who has just completed a job and earned yourself £100, and you record it in your books under revenue. On the accrual method of accounting, you will be required to record this amount straight away regardless if the customer decides to pay you on the spot or be billed at a later date, unlike the cash accounting method which requires you only to record it once you have received the cash.
Cash accounting is often used by sole traders, contractors and other professions that can identify a change in their income, and it only requires a basic level of bookkeeping skills to maintain the records. However, as a business develops they will often find themselves shifting to accrual accounting. Potential investors, banks and government agencies demand to see your financial statement produced on the accrual system. GAAP (Generally Accepted Accounting Principles) will only accept accrual accounting statements because it gives them a more accurate picture of a company's financial position and prevents any drawbacks that are usually made when using the cash accounting system such as;
Tie lags in the occurrence of the transaction and its recognition
It does not coincide with matching concept
The table below illustrates a few differences between the two accounting methods:
GAAP much prefers the accrual accounting method because it represents a company’s business activities, unlike cash accounting. For example, let’s say you run a Christmas tree business that sells Christmas trees to merchants who then sell to the public. Moreover, your busiest sales period is between early November to early December. With accrual accounting, it will reflect this as it will show you earning the bulk of your income during that period, although you might not receive payment from vendors until January. However, the information recorded under cash accounting won't be an accurate representation of your busiest sales period as it would appear to be in January. GAAP want to prevent businesses from misrepresenting their business activities by manipulating the timing of its cash flow numbers. On the cash flow accounting system a company might evade declaring a loss for a particular month like June for example, and hold off paying its bills until 1st July. Furthermore, If the business predicts that September is going to be a quiet month in terms of sales figures, then it might tempt them to prop up the numbers by postponing the bill dates for some of their customers so that they receive payment by 1st September. If a company intentionally goes out of their way to manipulate their numbers and to deceive the timings and revenue of expenses on the accrual account system, then they will be committing fraud. A business can’t pay for bills using revenue as it will require cash payments to cover them. So, cash flows are equally important to companies using accrual accounting as cash accounting. Hence, why GAAP advises companies to produce regular cash flow statements so that they can monitor cash coming into the business, which is separate from the revenue and expenses that get booked on the income statement, if you consolidate both practices together, it will unveil a bigger picture of how a business earns its money and when they receive it. Major discrepancies between the two can cause issues for the business like if revenue was recorded before the company earned it, and before it was billed to the customer.
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