Reference no: EM131089407

Methods of Calculating Performance of an Accounting Period

Cash Basis of Accounting

Cash basis of accounting is an accounting method used to measure performance whereby expenses are recorded when cash is paid out whereas income is recorded when cash is received. Cash basis means actual cash inflows and outflowsof cash(Cecil, H. W. et. al., 2011). It does not conform to the provisions of Generally Accepted Accounting Principles. It also leaves a time gap between recording the sale or purchase and payment or receipt of money. The factor, therefore, makes it unsuitable management tool. The method is more suitable for small organizations which transact mainly in cash.

Accrual Basis of Accounting

Accrual basis of accounting constitutes that accounting method used to measure performance as well as the position of the organization while recognizing the economic events regardless of the time of the cash transaction. The method applies the matching concept whereby revenues are matched to the expense at the operation time. "Accrual basis of accounting in accordance with International Public Sector Accounting Standards (IPSASs)" (IFAC, April, 2002).The desire for this method arose due to the increased complexity of business transactions as well as the need for more accurate financial information. The method also facilitates cash outflows, or inflows are combined with future expected cash flows which give a more accurate current financial situation of the organization.

Advantages and Disadvantages - Cash Basis of Accounting

Given its advantages, Cash accounting method is simple to apply. It simply states any amount reflecting in the account is a revenue and if it leaves it's expensed. It's also crucial as it gives an accurate picture of how much cash at hand is available in the organization during a given period. It also ensures taxes are not paid for monies not yet received. As such it improves cash flow and avails funds for tax expenditure. It's sufficient for companies that are paid in advance for their services and pay for their inventory at the time of delivery. The method avails sufficient details for accurate record keeping. On the other hand, the method is faced with some challenges. Since it does not allow for actual dates of purchase or sale tracking, as well as not using the matching concept, it becomes difficult in case payments for goods are not done immediately. In using the method, there exist some restrictions it's not applicable where the business a corporation, maintains inventory and where the gross receipts exceed five million dollars per annum.

Advantages and Disadvantages - Accrual Basis of Accounting

Accrual accounting method is useful as it shows an accurate flow of the business income as well as its debts. Since it records expenses as well as revenues in the same period in their causal relation basest produces more accurate gauges of the organization's performance. The matching concept involving revenue and expense also allows more useful analysis of the organization. IRS makes it mandatory to follow accrual basis of accounting for calculating tax liability (Goodman, P. B., 2010). The method is also beneficial in that it's able to track historical trends. This is enabled through tracking of revenue and expenses as they are incurred. By the use of the method, it meets the GAAP and as such the organizations, the financial image is readily available to financial institutions as well as other investors. The method also faces some challenges. The use of the method is an expensive operation to the organization since more time as well as additional labor is incurred reviewing transactions. Its application is also considered to be difficult. Rules associated with revenue as well as expense recognition can prove to be complicated. Thus necessitating an expert (Accountant).

How Accountants Can Manipulate Profit in Accrual Accounting

The accrual method may allow accountants to be creative by decreasing or increasing profits of the period. "At the extreme, mounting accruals can point to earnings manipulation and outright fraud." (Fisher, D, 2011). For example, since invoices do not coincide with actual events, through guesswork and estimations the accountant can bring the dates of its payments closer thus recording higher profits for the period. This could be in his favor when making reports to show the organization is making a profit. The same may be manipulated to reflect the invoice dates of a later date thus decreasing the profits of the current period.

Example 1:

Suppose, X company sells goods for $12,000 on 31^st March, 2016, on credit terms of 15 days and it is the last day of accounting year. The accountant wants to minimize tax liability. He can manipulate by issuing invoice for the date 1^st April, 2016. The effect will be that this sale will not be entered in sale of fiscal year 2016. Thus, the sales and net profit will be reduced by $12,000 resulting in lower tax liability.

Example 1:

Suppose, ABC Co.gets an orderfor $22,000 on 25^thMarch, 2016 and the goods will be dispatched on 2^nd April. Here the accountant wants to increase the profit. He can manipulate the sales by issuing invoice on or before 31^st March. It will result in increasing sales by $22,000. As a result of it the profit will also increase by $22,000.