As a business owner or manager, one of your responsibilities is to understand which accounting system your business is using.
The two most common systems are: accrual accounting and cash accounting. Each system has many different attributes and each may tell a different story about the finances of a company.
In our previous article, we identified accrual accounting and cash accounting as key bookkeeping concepts every business owner and manager should know. In this article, we explore these concepts in more detail and explain why they really matter for a business.
So let’s start with how the two systems differ at their most basic level – recording income and expenses.
When exactly should a company record a sale or payment for goods or a service?
When the goods have been delivered or the service has been performed? When the money has actually been received for the goods or service?
Answer? It depends on which method of accounting the company is using!
Under the accrual accounting system, revenues are considered “earned” at the time the service is performed or the goods have been sold.
Under the cash accounting system, a company records revenue when payment is actually received. It does not matter when the goods were delivered or when the service was performed.
As always, an example will help!
A client orders 10 printer units from a distributor. The distributor delivers all of the 10 units on 2 May. The client pays the distributor on 5 June. In which month should the distributor record the income?
If the company is using accrual accounting, the distributor should record the income on 2 May. This is the date when actual delivery of all products was performed. Or in other words – when the income was earned.
Under the cash accounting system, the income will be recorded on 5 June, the date that payment was physically received by the distributor.
Similar to revenues, the period in which expenses will be recorded depends on the accounting system utilized by a company.
Expenses under the accrual system of accounting are recorded when they were actually incurred. Under the cash accounting system, expenses are recorded when paid by a company.
Another case scenario? Of course.
A computer retail shop receives an electricity bill on 5 October, for electricity usage between 1 September and 30 September. The owner pays the bill on 9 October. When should this utilities expense be recorded in the accounting books?
If the business uses accrual accounting, the electric charges should be recorded in September. The electricity was actually used and the charge incurred during this month.
However, if the business has elected to use the cash accounting system, then, the bill would be recorded in October – the month of payment.
For more information on how to optimize your accounting and bookkeeping processes in the retail industry, check our recent article on the importance of managing inventories.
Company owners and managers make business decisions on the basis of the information contained in their accounting records and financial reports.
Fully informed decisions however can only be made with accurate reporting through the use of proper accounting systems together with excellent bookkeeping practices that align with a company’s business model.
Accrual accounting is generally a more accurate system of accounting because it takes into account all income and expenses regardless of when money was paid or received.
For a company, the presence of incurred but unpaid expenses, or earned but uncollected income, could have a significant impact on a company’s accounts. By failing to make provision for such items in the books of accounts will fail to take account of payments due for work completed or goods sold.
This can distort financial statements and make it difficult to plan or generate financial forecasts.
On the other hand, the cash accounting system can be less accurate. One main issue is that cash accounting fails to take account of outstanding liabilities. See the section on “Focus” below for a more detailed explanation.
Incurring expenses or generation of income will not always be within the same period when cash is paid or collected. Suppliers, vendors and clients may all have different payment terms. Also, with cash accounting, a company only has a day-to-day overview of its finances – much harder to plan and make decisions.
So why would a businesses still use the cash accounting system?
One reason is that it is much simpler to compute and record. A business using this method will only have to record a sale or expense when money comes in or money goes out. Many smaller companies in the Philippines who deal only with small cash transactions and who may not have an accountant or access to an outsourced accounting provider will generally use the cash accounting system.
There is another reason – liquidity. Read on to find out more.
Cash accounting is more concerned with liquidity – the ease of converting an asset to cash. The most liquid form of asset is cash.
Cash accounting will enable a company to understand how much cash it has in the bank or to hand at a point in time.
For very small companies in the Philippines, liquidity is always a key consideration. Smaller companies will generally have a lower working capital with which to operate. As such, every bit of cash that comes in or goes out is likely to be important to the company on the particular day it comes in or goes out.
However, there is a real disadvantage to using the cash accounting system – uninformed cash flow planning.
If the company plans its cashflow solely on the basis of its bank balance at a point in time, it could lead to poor uninformed decision-making and serious financial issues in the future.
The accrual basis of accounting focuses on profitability – the amount of money the company makes relative to the cost of making that money.
Accrual accounting provides a much better view of the financial performance of a business as it takes into account monies earned during a particular period as against the services performed or goods sold during that period.
Accrual accounting also enables accurate cash flow planning. Accrual accounting allows a company to understand what income or expenses are falling due in the future and make key commercial decisions based on this information.
Accounting systems and taxation
While the accrual system of accounting provides the most benefits and advantages for companies, particularly from the perspective of cash flow planning, profitability and financial forecasting, the recording of income or payments may depend on the particular type of expense or income involved.
For example, withholding tax will become due on either an accrual or a payment – whichever one comes first. Why? Because withholding taxes and the actual income or expense must both appear and be applied within the same period.
Let’s take the case of advance rentals as an example.
A business owner rents office space. As part of the lease contract, he pays the advance rental, net of 5% withholding tax, in September. That rent will be applicable for the month of October. However, since the business owner withheld the tax in September, the expense should be recorded as an expense in September also. This is effectively cash based accounting.
If you require further information on withholding taxes and how they might apply to your business, check out our recent article on withholding tax obligations for businesses in the Philippines.
Here are some other form of expenses that must be recorded under the cash basis:
1. Interest expense on bank loans
2. Interest income on savings deposit
3. Small miscellaneous expenses
There are also accounts that should be recorded under the accrual accounting system. Here are some of the most common ones:
1. Sales – goods, must be supported with sales invoices
2. Service Revenues – ensure that there are official receipts
3. Payroll expenses – employee taxes must first be withheld before BIR allows it as an expense
4. Depreciation – as it can take years before the cost is fully recognized
Find out more about taxation in the Philippines for online businesses and marketplaces in our recent article on e-commerce and online transactions in the Philippines.
Have questions about your accounting systems?
CloudCfo are experts in helping companies get their accounting, bookkeeping and financial processes in order.
Our team can examine whether your company is using the correct system of accounting or if not, what can be done to resolve any issues. We can also assist with transitioning from a cash based system to an accrual based system.
If it is the case that your accounting systems are out of sync, catch up accounting might benefit your company – and we have real experience and expert knowledge in this area!