Question

Describe why you think accrual accounting helps the reader of financial statements better understand a company’s financial position, compared to cash basis accounting. Include in your answer a description of the matching concept and provide an example, taken from class lecture or assigned problems, of a transaction that honors the matching concept. It may help you to consider how net income is impacted by recorded revenue when it is earned rather than when cash is collected.

Content, concept application, and writing quality will impact your grade. There is no required minimum or maximum response length. Please use complete sentences and proper punctuation.

Answer 1

Answer: A. Accounting is the language of business; affairs of a business unit are communicated to others as well as to those who own or manage it through accounting information which has to be suitably recorded, classified, summarized and presented. To make the language convey the same meaning to all people, as far as practicable, and to make it full meaning, a number of concepts have been followed. Now for the purpose of bookkeeping mainly two (2) methods are followed such as

1) Cash Method

Under this method income is equivalent to cash received, expense is equivalent to cash paid. Thus, it is clear that the cash received in a specified period is the income of that period and the cash paid is the expense of that period. So, the difference between the cash received and cash paid is the profit. If an amount related to that particular period is not received within that period, it is not considered as the income of that period. Similarly, if an amount related to that particular period is not paid within that period, it is not considered as the expense of that period. Thus this method is very easy and it is followed by small traders.

This method cannot be treated as a scientific method because the conditions mentioned above are not found in actual practice in a large organization.  

2) Accrual Method

This is more practicable and scientific system followed in large organization. To find out income under this method, accrued revenues during a period are matched with accrued expenses. For the determination of the period of receipt, the criterion is to see in which period it has accrued and not the period in which it has been received. Similarly, the expenses are also determined on the same basis. We have to see the period to which they are related and not the period in which they are paid. In other words, we can say that expenses recognized not when a disbursement is made, but when a cost expires or is consumed in the creation of revenues.

As explained above in "accrual method", "accrued expenses" are recognized not when a disbursement is made, but when a cost expires or is consumed in the creation of revenues.

According to this concept, the profit is considered to be earned only when there is an increase in the owner’s equity i.e., capital. Selling goods on profit is an example of this type. How has the profit accrued can be understood if we study its two aspect. For example, a businessman sells good for $100,000. Cost of its production is $60,000. One transaction increases the assets while the other decreases it. When as a result of business transaction, there is increase in assets, there is a profit and there is decrease in assets where there are expenses. Now in this case there is a profit of $40,000 in a particular period. Hence, when transaction takes place in a particular period its impact gets reflected in the financial statement of that period since it gets accrued in that period only. In this particular case both the expenses occurred and revenue earned will be shown in the same period in the income statement there by fulfilling the matching principle.

Hence, from the above it can be concluded that accrual accounting helps the reader of financial statements better understand a company’s financial position, compared to cash basis accounting.