Accounting systems have been used for thousands of years. As businesses grew, people to keep track of costs, profits, and losses invented accounting systems. Modern accounting measures and communicates financial information about an economic entity. This information is used to plan, control, evaluate, and make decisions about a business. The process begins with bookkeeping, which records transactions, such as checks and invoices, and summarizes these transactions in financial statements. Financial managers use the financial statements to raise and spend cash and make intelligent financial decisions. This section defines accounting and contrasts it with bookkeeping and finance functions.
Points to Remember
• Accounting is an information system that measures, processes, and communicates financial information about an identifiable economic entity.
• Bookkeeping, primarily a mechanical and repetitive record keeping function, is a subset of accounting.
• Finance is concerned with raising and using cash.
• Accounting supplies information about the company to financial managers so they can make intelligent financial decisions.
• Accounting enables managers to intelligently plan and control the business and make decisions based on objective information.
There are two basic accounting methods available to most small businesses: cash or accrual.
Cash method. If you use the cash method of accounting, you record income only when you receive cash from your customers. You record an expense only when you write the check to the vendor. Most individuals use the cash method for their personal finances because it's simpler and less time-consuming. However, this method can distort your income and expenses, especially if you extend credit to your customers, if you buy on credit from your suppliers, or you keep an inventory of the products you sell.
Accrual method. With the accrual method, you record income when the sale occurs, whether it is the delivery of a product or the rendering of a service on your part, regardless of when you get paid. You record an expense when you receive goods or services, even though you may not pay for them until later. The accrual method gives you a more accurate picture of your financial situation than the cash method. This is because you record income on the books when it is truly earned, and you record expenses when they are incurred. Income earned in one period is accurately matched against the expenses that correspond to that period, so you get a better picture of your net profits for each period.
CASH VS. ACCRUAL ACCOUNTING
All businesses need to choose one of these methods of accounting: cash or accrual.
It's important for you to understand the basics of the two principal methods of keeping track of a business's income and expenses: cash method and accrual method (sometimes called cash basis and accrual basis). In a nutshell, these methods differ only in the timing of when transactions both sales and purchases are credited or debited to your accounts. If you use the cash method, income is counted when cash (or a check) is actually received and expenses are counted when actually paid. But under the more common accrual method, transactions are counted when they happen regardless of when the money is actually received or paid.
So with the accrual method, income is counted when the sale occurs, and expenses are counted when you receive goods or services you don't have to wait until you see the money, or until you actually pay money out of your checking account. With some transactions, it's not so easy to know when the sale or purchase has occurred. The key date here is the job completion date. Not until you finish a service or deliver all the goods a contract calls for can do you put the income down in your books. If a job is mostly completed but will take another 30 days to add the finishing touches, technically it doesn't go on your books until the 30 days pass.
Say you purchase a new laser printer on credit in May and pay $1,000 for it in July, two months later. Using cash-method accounting you would record a $1,000 payment for the month of July, the month when the money is actually paid. But under the accrual method, the $1,000 payment would be recorded in May, when you take the laser printer and become obligated to pay for it. Similarly, if your computer installation business finishes a job on November 30, 2002, and doesn't get paid until
January 10, 2003, you'd record the payment in January 2003 if you use the cash method. Under the accrual method the income would be recorded in your books in November of 2002.
The most significant way your business is affected by the accounting method you choose involves the tax year in which income and particular expense items will be counted. For instance, if you incur expenses in the 2002 tax year but don't pay them until the 2003 tax year, you won't be able to claim them in 2002 if you use the cash method. But as you should now understand, you would be able to claim them if you use the accrual method, since the very essence of that system is to record transactions when they occur, not when money actually changes hands.
Zara runs a small flower shop called ZuZu's Petals. On December 22, 2002, Zara buys a set of new lighting equipment for her shop for which she will be billed $400. She installs the lighting equipment that day, but according to the terms of the purchase doesn't pay for it for 30 days. Under her accrual system of accounting, she counts the $400 expense during the December 2002 accounting period, even though she didn't actually write the check until January of the next year. This means that Zara can deduct the $400 from her taxable income of 2002.
Scott and Lisa operate A Stitch in Hide, a leather repair shop. They're hired to repair an antique leather couch, and they finish their job on December 15, 2002. They bill the customer for $750, which they receive on January 20, 2003. Since they use the accrual method of accounting, Scott and Lisa count the $750 income in December 2002, because that's when they earned the money by finishing the job. This income must be reported in their 2002 tax return even though they don't receive the money that year.
The cash and accrual methods can produce the same results. As you can readily see, the results produced by the cash and accrual accounting methods will only be different if you do some transactions on credit. If all your transactions are paid in cash as soon as completed, including your sales and your purchases, then your ledgers will look the same, regardless of what method you use.
Tax Years and Accounting Periods
Income and expenses must be reported to the IRS for a specific period of time, called your tax year, your accounting period or your fiscal year. But unless there is a valid business reason to use a different period, or unless your business is a corporation, you'll have to use the calendar year, beginning on January 1 and ending on December 31. Most business owners do use the calendar year for their tax year, simply because they find it easy and natural to use. If you do want to use a different period, you must request permission from the IRS by filing Form 8716, Election to Have a Tax Year Other Than a Required Tax Year. Also, your fiscal year can't begin and end on just any day of the month; it must begin on the first day of a month and end on the last day of the month one year later.
Most businesses that have sales of less than $5 million per year are free to choose which accounting method to adopt. But if your business stocks an inventory of items that you will sell to the public, the IRS requires that the accrual accounting method be used. Inventory includes any merchandise you sell as well as supplies that will physically become part of an item intended for sale.
Whichever method you use, it's important to realize that either one only gives you a partial picture of the financial status of your business. While the accrual method shows the ebb and flow of business income and debts more accurately, it may leave you in the dark as to what cash reserves are available which could result in a serious cash flow problem. For
instance, your income ledger may show thousands of dollars in sales, while in reality your bank account is empty because your customers haven't paid you yet.
And though the cash method will give you a truer idea of how much actual cash your business has, it may offer a misleading picture of longer-term profitability. Under the cash method, for instance, your books may show one month to be spectacularly profitable, when actually sales have been slow and, by coincidence, a lot of credit customers paid their bills in that month. To have a firm and true understanding of your business's finances, you need more than just a collection of monthly totals; you need to understand what your numbers mean and how to use them to answer specific financial questions.
Pros and cons. The cash method is easier to maintain because you don't record income until you receive the cash, and you don't record an expense until the cash is paid. With the accrual method, you will typically record more transactions. For example, if you make a sale on account (or, on credit), you would record the transaction at the time of the sale, with an entry to the receivables account. Then, when the customer pays their bill, you will record the receipt on account as another transaction. With the cash method, the only transaction that is recorded is when the customer pays the bill. If you are using computer software to do your accounting, this is probably not a big concern, since the computer program automates much of the extra effort required by the accrual method. Another issue to be considered is the accounting method you use for tax purposes. For convenience, you probably want to use the same method for your internal reporting that you use for tax purposes. How!
ever, the IRS permits you to use a different method for tax purposes. Some businesses can use the cash method for tax purpose. If you maintain an inventory, you will have to use the accrual method, at least for sales and purchases of inventory for resale. We recommend the accrual method for all businesses, even if the IRS permits the cash method, because accrual gives you a clearer picture of the financial status of your business. You probably need to keep a record of accounts receivable and accounts payable anyway, so you are already keeping track of all the information needed to do your books on the accrual basis. If you are using a computer program, there really isn't much extra effort involved in using the accrual method.
MODIFIED CASH BASIS OF ACCOUNTING
Modified cash basis financial statements use a combination of cash basis and accrual basis financial reporting. These financial statements report all accounts from cash transactions and from all other sufficiently supported modifications that were adopted. Reviewed or audited modified cash basis financial reports should include the same items required of GAAP financial statements. Distinction among modified cash basis, cash basis, tax basis and accrual basis accounting is made.
It is often suggested that preparing financial statements on the income tax basis is a cost-effective means of financial reporting because much of the cost of preparation is absorbed in the preparation of the tax return. In addition many accountants believe the disclosure requirements for income tax basis financial statements are less demanding than those required by "full" GAAP. However, IRS regulations have become so complex that many accountants do not feel comfortable with an SAS 62 report stating that the financial statements are in accordance with the income tax basis when ultimately only an IRS audit can determine compliance with tax regulations. Other problems associated with income tax basis financial statements relate to choices within the tax law, such as the choice between cash, accrual, or modified cash basis. Choices made on the tax return are made to affect a company's tax return are made to affect a company's tax liability with little regard for their effect on!
the usefulness of the financial statements that may result. For example, choices that lower taxable income on the tax returns and net income on the tax basis income statement may produce a financial picture that leads to higher borrowing costs. Since tax choices may change from year to year a consistency or comparability problem may arise.
What is GAAP?
GAAP is an acronym that stands for Generally Accepted Accounting Principles. Members of the accounting profession, through associations and individual input into the process, have over the years worked to establish accounting principles accepted by both the accounting profession and the public that relies on the profession's expertise.
For public sector accounting, GAAP are compiled from 22 sources. These sources are broken down into a hierarchy comprised of six levels. The public-sector accounting hierarchy established by SAS (Statements on Auditing Standards) - 69. This hierarchy helps to ensure that data is "Present[ed] Fairly in Conformity with Generally Accepted Accounting Principles."
Who develops GAAP?
1) The period from 1939 to 1959:
The Committee on Accounting Procedure (CAP) of the American Institute of Certified Public Accountants (AICPA).
The CAP issued 51 Accounting Research Bulletins (ARB).
2) For the period from 1959 to 1973:
The Accounting Principles Board (APB) of the AICPA.
The APB consisted of 18 to 21 members.
The APB issued 31 APB opinions.
3) From 1973 to present:
The Financial Accounting Standards Board (FASB) develops GAAP.
The FASB has 7 board members.
The FASB issues the Statement of Financial Accounting Standards (SFAS).
As of July 1999, 137 SFAS have been issued.
The FASB also issued the Statement of Financial Accounting Concepts (SFAC). SFAC provides a theoretical framework for the development of accounting principles.
However, SFAC themselves are not a part of GAAP.
The Emerging Issues Task Force (EITF), which was created by the FASB in 1984 and has 13 members, issues Emerging Issues Task Force Statements to address the current accounting issues in a timely manner.
The Mission of the Financial Accounting Standards Board
The mission of the Financial Accounting Standards Board (FASB) is to establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors and users of financial information.
Accounting standards are essential to the efficient functioning of the economy because decisions about the allocation of resources rely heavily on credible, concise, transparent and understandable financial information. The public in making various other kinds of decisions also uses financial information about the operations and financial position of individual entities.
To accomplish its mission, the FASB acts to:
1) Improve the usefulness of financial reporting by focusing on the primary characteristics of relevance and reliability and on the qualities of comparability and consistency;
2) Keep standards current to reflect changes in methods of doing business and changes in the economic environment;
3) Consider promptly any significant areas of deficiency in financial reporting that might be improved through the standard-setting process;
4) Promote the international convergence of accounting standards concurrent with improving the quality of financial reporting; and
5) Improve the common understanding of the nature and purposes of information contained in financial reports.
The FASB develops broad accounting concepts as well as standards for financial reporting. It also provides guidance on implementation of standards. Concepts are useful in guiding the Board in establishing standards and in providing a frame of reference, or conceptual framework, for resolving accounting issues. The framework will help to establish reasonable bounds for judgment in preparing financial information and to increase understanding of, and confidence in, financial information on the part of users of financial reports. It also will help the public to understand the nature and limitations of information supplied by financial reporting.
The Board’s work on both concepts and standards is based on research aimed at gaining new insights and ideas. The FASB staff and others, including foreign national and international accounting standard-setting bodies, conduct research. The Board’s activities are open to public participation and observation under the "due process" mandated by formal Rules of Procedure. The FASB actively solicits the views of its various constituencies on accounting issues.
The Board follows certain precepts in the conduct of its activities. They are:
1) To be objective in its decision making and to ensure, insofar as possible, the neutrality of information resulting from its standards. To be neutral, information must report economic activity as faithfully as possible without colouring the image it communicates for the purpose of influencing behaviour in any particular direction.
2) To weigh carefully the views of its constituents in developing concepts and standards. However, the ultimate determinant of concepts and standards must be the Board’s judgment, based on research, public input and careful deliberation about the usefulness of the resulting information.
3) To promulgate standards only when the expected benefits exceed the perceived costs. While reliable quantitative cost-benefit calculations are seldom possible, the Board strives to determine that a proposed standard will meet a significant need and that the costs
it imposes, compared with possible alternatives, are justified in relation to the overall benefits.
4) To bring about needed changes in ways that minimize disruption to the continuity of reporting practice. Reasonable effective dates and transition provisions are established when new standards are introduced. The Board considers it desirable that change be evolutionary to the extent that it can be accommodated by the need for relevance, reliability, comparability and consistency.
5) To review the effects of past decisions and interpret, amend or replace standards in a timely fashion when such action is indicated.
6) The FASB is committed to following an open, orderly process for standard setting that precludes placing any particular interest above the interests of the many who rely on financial information. The Board believes that this broad public interest is best served by developing neutral standards that result in accounting for similar transactions and circumstances in a like manner and different transactions and circumstances should be accounted for in a different manner.
In March 2001, the IASC Foundation was formed as a not-for-profit corporation incorporated in the State of Delaware, USA. The IASC Foundation is the parent entity of the International Accounting Standards Board, and independent accounting standard setter based in London, UK.
Effective 1 April 2001, the International Accounting Standards Board (IASB) assumed accounting standard setting responsibilities from its predecessor body, the International Accounting Standards Committee. This was the culmination of a restructuring based on the recommendations of the report Recommendations on Shaping IASC for the Future.
The IASB structure has the following main features: the IASC Foundation is an independent organisation having two main bodies, the Trustees and the IASB, as well as a Standards Advisory Council and the International Financial Reporting Interpretations Committee. The IASC Foundation Trustees appoint the IASB Members, exercise oversight and raise the funds needed, whereas IASB has sole responsibility for setting accounting standards.