Demerits of Cash Basis Accounting by stariya


									                                                              Demerits of Cash Basis accounting 1

                               Demerits of Cash Basis Accounting

       The major difference between the two accounting methods is in the recording of revenues

and expenses. In cash basis accounting, expenses and revenues are recorded when cash is

actually paid and received respectively, irrespective of whether they were actually invoiced

(Diamond, 2002). Most businesses and accounting professionals use accrual basis accounting

method as compared to cash basis accounting as this is required by law (Beechy, 2007). On the

other hand, non-profit making organizations have the discretion to choose between the two

accounting methods when preparing their financial statements.

       For example, if a firm makes a sale in June but payment expects no payment until July,

the income from the sale is recognized in June (immediately it was earned) and the amount

accrued to the company is entered in accounts receivables. On the contrary, under the cash-

basis approach, sales revenue is not recorded until July when the firm actually receives the cash.

This method is relatively easier to use as it requires fewer journal entries. In this example, sales

revenue is not matched-up to the cost of sales (for example, the salesperson's salary) incurred by

the firm to make the sale. Consider a payroll expense that is recorded in books for June, since

the revenue is not recognized by the firm until July; the firm’s accounting records will not

portray a true picture of what actually took place. Furthermore, cash basis approach will still

result in a mismatch of revenues and expenses even if payment was received right away (in

June), but the salesperson's salary was not paid until July. The method simply makes no attempt

to match its expenditures with revenues generated. This implies that the income statement and

the cashbook are not true reflections of the recent business activities and conditions.
                                                             Demerits of Cash Basis accounting 2

       Another example is when a firm purchases expensive equipment, the purchase is charged

in the year of purchase yet the equipment is meant to last a number of years. In this case, income

is the year of purchase is understated while it will be overstated in subsequent years. In addition,

the Internal Revenue Services (IRS) prohibits the use of cash basis accounting when inventory

assets are involved (Donaldson, 2007).

       When the organization is big and more complex, cash accounting can no longer suffice.

In accounting, one of the primary objectives is to match revenues and expenditures as accurate as

possible. This implies that of most significance is for whom the organization is preparing the

books. While non-profit making organizations and management of small businesses might be

contented with cash accounting, larger organizations and government agencies that disburse

funds according to budgetary allocations are generally required to submit audited financial

statements. This is where cash accounting becomes more challenging. As a matter of fact, cash

basis accounting is not a generally accepted accounting principle (GAAP). This implies that

auditors are more likely not to issue an "unqualified opinion," rather than rendering it as an

"other comprehensive basis of accounting." As is in financial reporting standards, qualified

opinions are not necessarily negative, but can easily raise investors’ eye brows.

        Cash accounting's overriding advantage of simplicity is also its major downside. Just as

lenders and investors need to assess where their money is going, firms are obliged to choose a

financial reporting method that satisfies the needs of their users (Matheson, 2002).
                                                          Demerits of Cash Basis accounting 3


Diamond, J. (2002). Performance Budgeting: Is Accrual Accounting Required? Working Paper

       WP/02/240. Washington, DC: IMF.

Matheson, A. (2002). Better Public Sector Governance: The Rationale for Budgeting and

       Accounting Reform in Western Nations. OECD Journal on Budgeting. Vol. 2(1).

       December. pp. 44–45.

Donaldson, S. A. (2007). Federal Income Taxation of Individuals: Cases, Problems and

       Materials, 380, 2nd ed. Thompson-West.

Beechy, T. H. (2007). Does Full Accrual Accounting Enhance Accountability? The Innovation

       Journal: The Public Sector Innovation Journal, Vol.12(3), pp. 2-18. Viewed October 17,

       2010, from:

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