Cash vs. Accrual basis Accounting
The accounting system is based on two types distinct approaches. Once chosen, it becomes a default accounting system and all records are made according to its rules. A company chooses its accounting basis according to the way it handles financial transactions. Cash basis and accrual accounting are the accounting approaches that deal with recording business transactions.
When a business only accepts financial transactions to be made at the time of purchase, the accounting system records all transactions based on cash accounting. This means that the entire fee/price of a service/goods has to be paid at once at the time of the purchase. Having a cash-based accounting system means more liquidity.
This type of accounting is convenient if the business and the number of transactions are small. This also makes matters easier for cases of sole proprietorship. When a business is owned by only one person, there is no need for income statements and balance sheets. There is no obligation to any other party. However, Business processes are not always so limited or simple. While this system may be suitable for businesses such as shops, large companies have to use a different one to maintain their financial records.
Not all businesses can or are willing to pay for a purchase at one time, especially if their business transactions include large figures by nature. Using cash basis accounting can be very limiting if not impossible. In order to keep the business going and allowing different companies to engage in business deals, larger companies use the accrual accounting system.
Contrary to cash-based accounting, accrual accounting is more complicated and harder to maintain. There reason for this complication is that there may be more than one transaction per business deal. Here is an example of how accrual accounting works:
Lotus Ltd. received an order of 247 items from a company. The invoice indicates a total price of €95,600. According to the P/I, %10 of the total purchase price has to made in advance, %40 upon receiving shipping documents, and %50 upon delivery.
Advance Payments and Accounts Receivables
This type of agreement cannot be recorded based on cash accounting. First, only a percentage of the fee is received at the time when the order is placed, known as advance payment. Second, there will be three financial transactions for one purchase, and finally, the order has to be recorded as a purchase with the difference that the payment will be received in the future.
Although this type of business holds a risk of not receiving payments (on time or at all), it allows companies to do business with more freedom. Offering more choices means receiving more deals. This advantage comes with a necessity to keep track of all transactions until they are fully paid. Accrual accounting requires several entries for the example above.
At the time of order placement
Advance payment: %10x €95,600
Accounts receivable: %90x €95,600
The system sees the order as a purchase (the money is not received but it will be). Therefore, it is considered an income despite the fact that the company will receive the fee later. No matter when or if the company receives its money, the declaration of an income necessitates the business to pay its tax. Yet it also keeps a record of what it is owed in the accounts receivable. It also keeps a record of the advance payments it has received.
Both advance payments and accounts receivable are listed within current assets (if the payments are to be received within the current fiscal year). However, if the account receivable is unlikely to be paid, then it has to be declared as an expense or a liability.
The Need for Collection Procedures
Accounts receivable collection period is important to businesses. Therefore, companies usually devise a collection system in which they determine the order of the people who are involved in the process and the time span between every action that has to take place. This process may involve sales persons, a member from the financial department, and in cases where payment is unlikely to be received, a lawyer.
Setting a collection procedure in the organization clarifies the approach to following future payments, avoiding confusions or loss of track of payments. It also enables businesses to be aware of their current and future cash flows, so they can prevent tax payment on earning that they never made.
Cash and accrual accounting are both used for recording financial transactions. Accrual accounting is prominent in businesses because it make is easier to make business deals. It helps them make purchases at one time but make payments later. Maintaining financial transactions is more complicated than in cash basis accounting, yet it is necessary. An accounts receivable collection procedure helps keeping track of payments through a systematic approach, preventing lengthy collection periods.