Cash and Accrual Accounting

Cash and Accrual Accounting

Businesses can either use cash or accrual accounting methods for sales. These accounting bases are handled differently and have an impact on the net income of the firm (Adamyk & Adamyk, 2017). Mostly, the cash basis accounting method is used by the small business since it simple and ensures that the firm has adequate cash to settle current expenditures. But as the business grows, they do need to switch to the accrual method as guided by the Generally Accepted Accounting Principles. Further, investors, lenders, and government agencies require that businesses use the accrual accounting method since it presents more accurate data as compared to the cash basis.

Therefore there is a distinction between the two accounting methods, which affects the net income. First, the cash basis of accounting requires that revenue recognition is done when the cash is received and when expenses are paid (Adamyk & Adamyk, 2017). In the case of BizCon, they cannot record goods sold on credit until the actual payment is made if they used the cash basis formula. That means that accounts receivable and payables are not recognized in this form of accounting. According to the US Securities Exchange Commission, cash basis accounting is highly recommended since it is easy to determine when transactions occurred, thereby no need to track receivables and payables. For instance, if a company buys equipment and decides to pay after one year, the expenditure will not be recognized after acquiring it but instead after one year when the payment has been made. The US Securities Exchange Commission prefers this method since it gives an actual value of cash at a given time.

On the other hand, Generally Accepted Accounting Principles require that businesses use the accrual method. Revenues and expenses are recognized when they are earned regardless of the period the actual payment will happen (Clikeman, 2018). BizCon has used the technique since it has an appealing net income statement though there is a cash problem in the firm. The method is used since it has a realistic idea of income that can be relied on even in the future. Further, it helps in identifying the ability of the firm to earn revenue. The downside of the method is that it may not provide real value to the cash flow of the business. The matching principle in accrual accounting requires that expenses incurred in earning revenue are recorded at the same time (Clikeman, 2018). For instance, the acquisition of equipment on credit will be recorded when it is made. Other expenses, such as transport costs will also be recorded at the same time. The selling of goods by BizCon on credit requires that revenues are recognized immediately, even if the debtors will pay in 6 months.

How BizCon could have positive net income and yet run out of cash

The ability of the firm to record positive net income however they are out of cash, is contributed by the Accrual accounting method as per the GAAP guidelines. BizCon reported a favorable net income since all the amount sold credit was recognized in the revenue despite that they did not receive the actual payment (Adamyk & Adamyk, 2017). Bizcon Company’s first-year operations recorded an explosive sales. When sales increases, they increase the revenue, which indicates the ability of the company generating cash. But, they focused to give the customers an extended time of 6 months for the payment of services. That means that under the GAAP method, all the sales were recorded immediately they were earned. The intention was to create trust with customers as well as foster high sales. By the end of the financial year, they still had sales that were recognized as revenue though they had not been paid. That resulted in positive net income.

Also, the fact that the equipment suppliers did not give the same privilege to BizCon as they had given their clients caused the shortage of cash. Mostly, creditors and suppliers find it hard to provide credit to a new firm since they do not have a historical financial position. Similarly, the company did not have a history to indicate its trustworthiness to suppliers. That made them make cash payments to all the expenses that were required to earn revenue, but there was no cash gain immediately. So, in the income statement, high revenues were recorded as well as the expenses. The expenses were paid in cash, which was an outflow, but there was no matching cash inflow into the company’s accounts. So, the fact that revenue is recognized when it is earned does not translate to real cash account under the accrual basis of accounting. But the method is widely used since it gives an accurate ability of the firm to generate revenue. rv

References

Clikeman, P. M. (2018). North Pole Car Wash: A Teaching Case Demonstrating The Advantages Of Accrual Basis Accounting. Journal of Business Case Studies (JBCS), 14(3), 17-24.

Adamyk, O., & Adamyk, B. (2017). Accounting methods for public sector entities. CZECH JOURNAL OF SOCIAL SCIENCES, BUSINESS, AND ECONOMICS.–2017.