Question

One of the first decisions a new company must make is whether to use a cash based or accrual based system of reporting. explain three factors a company must consider when deciding which accounting method to use. Discuss how each method would affect these factors. If you were to open your own business, which reporting method would you choose?

Answer 1

Three factors which affect the decision about choosing accounting method :

1. Nature of business transactions

2. Statutory compliance

3. Depicting actual financial position

How each method would affect these factors? :

1. Nature of business transaction : If the business only have cash transactions and there is almost no credit transactions , then for simplicity cash basis may be preferable .But when there are lots of credit transactions with outstandings and prepaid expenses and accrued and advance income then accrual basis will solve the purpose of accounting.

2. Statutory compliance : For companies IRS specifies that accrual basis to be used for accounting purposes for companies because it provides the actual financial results of the company . For legal support and to carry on accounting as per the preview of the law and IRS , accrual basis to be used for companies.If there is no legal compulsion then cash basis can be used for doing accounting records keeping because it is really easy to do and less time consuming.

3. Depicting actual financial position : Cash basis only records cash transactions and not recognized any non cash transactions, so it provides only limited financial information. For companies to make the shareholders and others stakeholders more informative accrual basis to be applied for maintaining accounting records .

If you open a new business ,which reporting method would be chosen ? :

For a newly opened business it is better to use accrual basis reporting method. Business normally have certain credit transactions like credit sales ,credit purchase, outstanding payment ,accrued income etc. Accrual basis only shows the effects of such above mentioned non cash transactions in the financial statements.

Accrual basis also consider the value of closing stock during calculation of profit, where as in cash basis closing inventory never been considered while calculating gross profit .Which is not at all logical and scientific.

Accrual basis recognized by IRS and several tax authorities and it only follows matching principle, which the cash basis does not. Actual net profit or loss can be properly calculated only by using accrual basis method.Cash basis is just the difference between cash received and cash payment to calculate profit or loss.