Coming to Lagos Business School, will make you everything you never thought you would be…lol.
Corporate Financial Accounting has been one of the interesting new adventures I have get to embark on during this period of MBA. I will focus on what I learnt so far on the cash concept and accrual concept of accounting.
Cash Basis of Accounting
Cash Basis of Accounting uses receipts and payments of cash to record incomes and expenses.
Therefore, under the cash basis of accounting, if a business makes salary payments of January, 3 months later in April, it will be considered as expenses in the month of April, since that is when the cash was paid. Also, if the same business pays advance salary for the month of May in April, then it will be considered as an expense for April.
Similarly, the time businesses spend doing value addition to their products, shows up in the books as expenses. Only when sale is closed and cash comes in the door, is income recognized. Cash basis of accounting considers advance payments as income since the cash has been received.
There are obvious problems with cash basis of accounting. To wit:
Expenses Tend to be Cluttered:
It is not uncommon for businesses to negotiate trade credit for themselves. Under the terms of trade credit, businesses use raw materials over a period of time and then make one lump sum payment for the use. Under the cash basis of accounting, all expenses appear on the financial statements at one go when the payment is made. This clutters expenses on the financial statements.
Income Tends to be Cluttered:
Just like we use credit from our suppliers, the businesses that deal with us also tend to use our credit. They also make our payments in one lump sum. Therefore just like the expenses, the income also tends to be cluttered.
Financials Become Unpredictable:
Under the cash basis of accounting, there will be no or very little income and expenses in some months and very large income and expenses in some others. This will be because of the cluttering effect. As a result, the financials become unpredictable.
Accrual Basis of Accounting
On the other hand, accrual basis of accounting, recognized income when it is earned and recognizes expenses when they are incurred:
- The business will expense raw materials consistently as they are used and not in one single charge when they are paid for.
- The business will record income when all responsibilities pertaining to the sale have been fulfilled and the business has a right to claim money from the customers.
- Advance cash received will be treated as a liability. The business will either have to return the cash back or provide services in lieu of the same.
We use a combination of cash and accrual basis of accounting. The profit and loss account and balance sheet are prepared as per accrual basis while the cash flow statement tells about the cash situation of the business. In preparation of Financial Statements of a business in Nigeria, we use the accrual concept basis.
What is the accrual basis of accounting?
Under the accrual basis of accounting, revenues are reported on the income statement when they are earned. (Under the cash basis of accounting, revenues are reported on the income statement when the cash is received.) Under the accrual basis of accounting, expenses are matched with the related revenues and/or are reported when the expense occurs, not when the cash is paid. The result of accrual accounting is an income statement that better measures the profitability of a company during a specific time period.
For example, if I begin an accounting service in December and provide N10,000 of accounting services in December, but don’t receive any of the money from the clients until January, there will be a difference in the income statements for December and January under the accrual and cash bases of accounting. Under the accrual basis, my income statements will show N10,000 of revenues in December and none of those services will be reported as revenues in January. Under the cash basis, my December income statement will show no revenues. Instead, the December services will be reported as January revenues under the cash method.
There will be a difference on the balance sheet, too. Under the accrual basis, the December balance sheet will report accounts receivable of N10,000 and the estimated true profit will be added to owner’s equity or retained earnings. Under the cash basis, the N10,000 of accounts receivable will not be reported as an asset, and the true profit will not be included in owner’s equity or retained earnings.
To illustrate a difference in expenses, we will assume that the heat and light expense that I used in my accounting service is metered by the utility on the last day of the month. The utilities that I used in December will appear on a bill that I receive in January and will pay on February 1. Under the accrual basis of accounting, the utilities that I used in December will be estimated and will be reported as an expense and a liability on the December financial statements.
Under the cash basis of accounting, the utilities used in December will be recorded as an expense on February 1, when the utility bills are paid. For financial statements prepared in accordance with generally accepted accounting principles, the accrual method is required because of the matching principle.
What is the difference between the cash basis and the accrual basis of accounting?
Under the cash basis of accounting.
- Revenues are reported on the income statement in the period in which the cash is received from customers.
2. Expenses are reported on the income statement when the cash is paid out.
Under the accrual basis of accounting.
1. Revenues are reported on the income statement when they are earned—which often occurs before the cash is received from the customers.
2. Expenses are reported on the income statement in the period when they occur or when they expire—which is often in a period different from when the payment is made.
The accrual basis of accounting provides a better picture of a company’s profits during an accounting period. The reason is that the income statement prepared under the accrual basis will report all of the revenues actually earned during the period and all of the expenses incurred in order to earn the revenues.
The accrual basis of accounting also provides a better picture of a company’s financial position at a moment or point in time. The reason is that all assets that were earned are reported and all liabilities that were incurred will be reported.
The accrual basis of accounting is required because of the matching principle.