Accounting is all about sorting, classifying and presentation of economic data. (Marshall, McManus & Viele, 2014, p.3) The very foundations of the whole accounting process are transactions, which are financial trades between companies (Marshall, McManus & Viele, 2014, p.33) and the reason of that process is the issuance of financial statements. There are two approaches of recording earnings, which result from transactions between entities. According to Dechow, (1994, p.4) earnings are crucial as they serve as a summary of company’s financial condition used by an extensive variety of users. There are two ways of collecting, recording and then compiling data into financial statement. It can be obtained on the basis of accrual accounting or on the basis of cash-flow accounting. The discrepancies between both of them has been a concern in the research world for years.
Accrual accounting basis states that revenues and expenses should be recognized at the time they are earned or incurred, regardless of when the money is transferred (Marshall, McManus & Viele, 2014, p. 49).
On the contrary to the accrual accounting concept, cash flow approach states that incomes and revenues are not counted until cash is actually transferred. Revenues are earned and expenses are incurred only after money changes hand. (Jack Diamond, 2002, p.4)
In this paper following question will be answered: what are the advantages and drawbacks of both accounting concepts. This paper will first cover the topic of advantages and disadvantages of accrual basis accounting followed by those of cash flow approach.
Organizations are obliged to keep their records on the premise of accrual accounting. The primary role of that concept is to overcome issues with gauging company’s performance
in the state of continuous operating. (Dechow, 1994, p.4) Accrual accounting concept gives firms more accurate depiction of their assets and budgetary duties, which allows them to properly manage the flow of their financial activity. According to Dechow (1994, p.8), accrual procedure of measuring earnings provides guidelines to the planning of cash flow recognition in earnings, so that earnings will more accurately reflect firm’s performance than realized cash flows. Moreover, income and debt can be more precisely assessed on the basis of accrual accounting.
Accrual accounting approach makes it more accessible for organizations to plan their future. According to Financial Accounting Standards Board (FASB), accrual approach enhances capability of earnings to gauge firm’s performance. Statement of Financial Accounting Concept No. 1, paragraph 44 issued by FASB states: ‘Information about enterprise earnings and its components measured by accrual accounting generally provides a better indication of enterprise performance than does information about current cash receipts and payments.’
Accrual accounting concept also has more benefits in the greater range of operations of governments. Governments for the most part have huge resources and liabilities, and disclosure of this data is a basic component of financial transparency and accountability. Aside from money stream, accrual accounting approach requires a full explanation of assets, liabilities, incomes and costs (Diamond, 2002, pp. 9-10) This entire picture gives key data for macro-fiscal management, furthermore serves as an effective tool for strategic planning.
On the contrary, the drawbacks of accrual accounting concept need to be taken into consideration as well. The most significant disadvantage of using the accrual-based accounting system is that it requires transactions to be recorded at the time they occur, which may lead to estimations and guesswork. According to Francis and Krishnan (1999, p.139) accruals require managers to subjectively assess future results, which may lead to impediment to the objective verification of company’s performance by auditors. As stated by Francis and Krishnan (1999, p.140), accrual accounting concept increases constitutional audit risk. Furthermore, estimation mistake in accruals can bring about the overstatement of assets, which thus prompts to potential asset recognition issues.
Accrual accounting approach may also lead to manipulation. As stated by Dechow (1994, p.5) financial management usually possess discretion over the acknowledgement of accruals, which can be used for opportunistic earnings manipulations. Since the management presumably have accurate information about firm’s ability to generate cash, information
asymmetry can occur and auditor can have hardships with assessing organization’s performance.
The other significant disadvantage of accrual accounting concept that needs to be mentioned in this paper is distortion of earnings persistence which may lead to security and shares mispricing. As stated by Richardson, Sloan, Soliman and Tuna (2001, pp.1-2), accrual segment of earnings is less constant than the cash flow part of earnings. According to the authors, investors do not thoroughly foresee the lower steadiness of less reliable earnings, prompting to significant security and share mispricing.
On the contrary to the accrual accounting approach, cash-flow accounting basis, which records transactions only when money transfer is involved, is more comprehensive to financial statement’s users. According to Diamond (2002, p.4) it is frequently stated that cash-flow accounting is more objective, as the acknowledgement and estimation of assets and liabilities rather than only cash, requires a more noteworthy measure of judgement. That leads to less distortion in assessing the company’s performance based on the cash flow approach and thus is easier for financial statement’s users to analyze company’s performance.
Furthermore, creating and auditing financial statements of the company which accounting system is based on the accruals brings about higher costs than generating the statement based on the cash-flow approach. (Bowen, Burgstahler, & Daley, 1987, p.724) Analyzing data collected on the accrual basis require more skills from an auditor and thus leads to the higher costs of that service.
Having written about cash flow advantages over accrual accounting, drawbacks of the first concept cannot be omitted in this paper. The most significant one, stated by Diamond (2002, p.4) is limited scope of cash flow approach, which is not satisfactory in demonstrating the effects of transactions bringing about cash flows outside the present reporting time frame. Furthermore, it is not possible to obtain full balance sheet in a cash system. According to the author, there are numerous transactions which are unattainable to capture in the cash accounts, since the only ledger conveyed forward is money balance. (2002, p.5)
A common issue ensuing from cash flow accounting is distortion of information of total costs resulting from provided services. As stated by Diamond (2002, p.9), assessing the costs of using capital assets paid for in previous years (i.e., depreciation costs) is regularly ignored. Moreover, reporting realized money streams over limited intervals of time is not unquestionably informative. This is on account of realized cash flows having timing and matching problems that make them ‘noisy’ measure of company’s execution. (Dechow, 1994, p.4)
The above depicts advantages and drawbacks of two accounting approaches, namely accrual and cash flow based accounting. The main advantage of accrual accounting concept is greater predictability of the future company’s performance and more accurate representation of its current position. Accrual accounting may also lead to manipulation and opportunistic use of information by financial management. Moreover, accrual accounting may be the reason of serious shares mispricing, as accrual segment of earnings is less stable than the cash flow part of earnings. On the other hand, the biggest advantage of cash flow accounting system is comprehensiveness to financial statement’s users. It is generally stated that cash- flow approach is more objective and leads to less distortion in assessing the organization’s performance. On top of that, auditing statement’s based on cash flow basis requires less skills and thus is cheaper. The main drawbacks of cash flow concept is limited scope, which is not satisfying in displaying the effects of transactions bringing about cash flow outside the present financial time frame. Cash flow approach can also lead to lack of good information on total costs of providing particular service.