types of accounting systems used in most organizations

 types of accounting systems used in most organizations

Introduction

As a business grows, the need to change financial statements becomes paramount. For a small business, simple accounting based on cash flow is enough, since the cash helps in offsetting any expenses and revenue can be calculated from the cash at the end of the financial year. However, growth in business and other already large organizations cannot rely on cash transactions for their financial statements. This is because these organizations rely on other firms and organizations for their survival and need to pay or be paid in advance for goods and services. A big corporation, for instance, when it opens up a new branch, pays for office premises and some suppliers for years ahead. Such transactions cannot be filled in a cash basis accounting system and thus the need to find other ways for accounting. Finally, any business, large or small, needs financial statements to know how the business is fairing and to plan. This research paper explains the types of accounting systems used in most organizations.

Cash Basis Accounting

Under the cash basis, cash flow in the business is recorded on the accounting statements in the period when the cash is received or paid (Warren et al., 2018). This implies that business income is the difference between cash receipts and payments. With the simplicity of the cash basis accounting, it is therefore used by individuals and small business, but a significant disadvantage to large enterprises (Warren et al., 2018).

Since cash basis accounting depends on immediate cash, it helps a business when cash flow is down. For instance, a business does not have to pay for taxes for goods sold with payment to be done in the next financial year. This helps the business have enough cash flow unit the fiscal year ends.

Cash-based accounting can make a business believe it is generating high revenue due to high cash flow, while in reality, the revenue is due to work done previously. Also, with its simplicity, cash-based accounting does not require a record of dates for transactions. This removes any accounts payable and accounts receivable from the financial statements and can cause difficulties for the business when the business has outstanding bills, for example (ref7—). Cash-based accounting does not reflect business performance, and there is a need for accrual based accounting.

Accrual Based Accounting

In accrual accounting, expenses and revenue are recorded during the period they occurred rather than the time they were received. Accrual accounting is accomplished by (ref5—):

1. Revenues are recorded when they are earned
2. Expenses are recorded when they are incurred

• The accounts have to be adjusted.

Accrual based accounting gives shows the income and expenditure of a business within a given period. This can help in planning and taking advantage of peak months that would otherwise not be visible if using cash based accounting (ref7—-). For long-term planning, accrual accounting is a must-have, since it shows when the business is slowing or speeding up over a given period (ref7—).

Even with its advantages, accrual based accounting has weaknesses. For a small business, accrual accounting can be complicated due to the financial reporting involved. In accrual accounting, finance records indicate money that is yet to be paid. This can make the business appear to have a lot of money while in the bank, the business has no money at all. For a small business, this can cause a financial crisis in the short-run (ref7—).

Revenue Recognition

For a given business, the functions and activities of the business are divided according to a given period. During the preparation of financial statements, not all activities are completed, and adjustments are necessary for balancing accounts. To adjust the accounts, there is a need to recognize revenues and expenses.

Revenue recognition principle states revenue is recorded when they are earned, which occurs at a different time from when the cash is received (Tracie et al., 2013). Thus, the revenues are reported in the period the goods or services are delivered. According to the Securities and Exchange Commission (SEC), the following must be met for any revenue to be recognized (re5—-):

1. Evidence of an arrangement must exist.
2. A good or service has been delivered.
3. The price of the goods or services is determinable to the buyer.
4. The collection of the products or services is assured.

For example, Jane, after establishing her business, gets a customer who wants designs for outdoor advertising. After Jane creates the design, the customer agrees to owe Jane for the work done, both had already decided on the price, and the customer has reassured Jane of payment after verifying the designs. Jane can now record the transaction as revenue by debiting and crediting the accounts affected. Recording the transaction can happen even before the customer pays for the services, as long as there is an expectation of the customer paying.

Accrual

accrual occurs when the incurred expenses or earned revenue has not been recorded (Warren et al., 2018). The financial statements using accrual record both cash transactions and any obligation to pay in the future and any cash to be received in cash. If the accrual is for the revenue, there is a debit on accounts receivable and a credit on the revenue account. For any expense accrual, there is a debit on the expense account and a credit on the liability account affected by the expense (Warren et al., 2018).

Accruals are made by adjusting the entries at the end of the business cycle for the financial statements to include them. One advantage of accruals is that it helps a business or company to record intangible assets and goodwill (ref8—-). Accruals help a business in knowing what it owes in the short-term and the expected revenue.

An example of accrual is bonuses. For the financial year ending 2019, the bonus paid to employees is not paid until the next fiscal year, which is 2020 (ref8—). The company has to debit the expense account as employees’ bonuses and credit the liability account for cash it owes its employees. All the records are supposed to be in the 2019 financial statement. In the financial year 2020, the employees will be paid their bonus, with the company crediting their cash account and debiting their liability account.

Unearned Revenue

Also called deferred revenue, it is the cash received in advance for providing goods and services (ref4—). Unearned revenue is a current liability since the cash received is an obligation for the business. With time, as the goods or services agreed upon are provided, the unearned revenue becomes earned revenue, and there is a decrease in liability. However, if the products or services are not delivered within 12 months, the unearned revenue is recorded as a long-term liability in financial statements.

One of the advantages of unearned revenue is the increase in cash flow for the business. This can help in offsetting bills and interest and purchasing more products for the business.

Trial Balance

The trial balance is a list of ledger accounts and the corresponding balances at a point in time (ref4—). The total debit balance equals to total credit balances in the trial balance. Some of the uses of trail balance include:

1. The trial balance is used to prove that the business accounts are balanced. This is because debit and credit balances match for a balanced account (ref5—).
2. Trial balances help in making financial statements. For instance, in the recording income statement, information about income and expenses is derived from the trial balance (ref3—).
3. Trial balances are also used in auditing. The early stages of auditing can use the trial balance for the ending balances to use them in audit procedures later on.
4. Trial balance is used in determining the accuracy of financial statements. For any debit, there is a corresponding credit. The omission of either of them is detected in a trial balance.
5. The trial balance gives a bird’s eye view of all the transactions in a business entity. With the entry of all balances and ledgers in the trial, balance provides a summary of how the business is functioning (“The Trial Balance,” 2019).
6. Since the trial balance gives a bird’s eye view of the business, it is used by financial institutions to know the borrowing capability of the business (“The Trial Balance,” 2019).

With the use of technology in accounting, the trial balance is mostly used where there are manual entries, not computerized entries. This is due to the many limitations that the trial balance has. Such limitations include:

1. Errors can be made that do not affect the final debit and credit balance. For example, omitting an entry still gives a balanced trial balance. Also, the incorrect amount can be recorded in the correct accounts. This balances the accounts but gives the wrong figures at the end of the trial balance (ref2—).
2. There is the possibility that the trial balance will not balance, showing errors in the accounts or its preparation.

Conclusion

The financial health of a system is determined using financial statements. The trial balances help in preparing for other financial statements in an organization. Also, the use of trial balance helps an organization when seeking loans from other financial institutions. Cash and accrual accounting helps a business in both the short and long term. Cash basis accounting helps in knowing the immediate cash a business has, and accrual accounting help in long-term planning of the business since it gives enough information about the business that cash basis accounting does not provide.