Accrual and cash basis differs in regard to recognition of revenue as well as expenses of a business. Cash basis recognizes income when cash is received. For example, when goods are sold at a profit the profit will be recognized when the buyer pays for the goods. Therefore, if a company uses cash basis of recording trasactions, when credit sales are made it is impossible to recognize any profit to be obtained from such sales till the time customer pays. In addition, cash basis requires expenses to be first paid then recorded. This means that any expense incurred and not immediately paid will not be immediately recorded. Cash basis is mainly used by households because they only need to keep track of their finances and they do not need to reconcile their books of account at the end of the year. It is therefore useful in determining the cash and bank balances, but, not appropriate in determination of income and expense of a specific trading period. However it is appropriate if business: sales, purchases and pays expense immediately i.e. no receivables or payables.
On the other hand, accrual basis requires income to be recorded immediately it is earned. It also requires all expenses to be recognized when incurred but not when paid. Therefore, credit sales are recorded as receivables in books of account and this are added to cash sales to arrive at net sales of the business. It can therefore be seen that accrual basis requires credit sales to be included in calculating gross profit. In addition, credit purchases should be added to cash purchases when determining purchases to be used in the profit and loss account. Accrual basis is therefore the best way of calculating profit and loss of a given accounting period especially if the business sell on credit, makes credit purchases and pays for its expenses at later dates.
According to the Committee on Sponsoring Organizations of the Treadway Commission Improper revenue recognition has been among the highest sources of fraudulent financial reporting in large and small firms. This improper recognition of revenue is aimed at intentional misrepresenting earnings aimed at giving false picture of performance of business. According to the article, the fraud has grown over years because many auditors are not very careful when probing financial accounts. It is therefore important for CPAs to be extra vigilant to prove whether recorded revenue was earned and when the revenue was recognized i.e. recorded in firm’s books of account accordingly. In determining any revenue recorded whether it was actually earned, CPAs must examine whether there is a business liability which has decreased in value or a business asset has increased in value.
There are two pre requisites for revenue recognition. First and fore most, the revenue must be earned and secondly the revenue must be realizable. For example, complete transfer of legal title of goods indicates earned sales revenue. The transfer can be proved by a delivery note; this may not however apply to special contracts where revenue is recognized prior to delivery of a service or product. These special transactions have created complexity of determining when to recognize revenue as earned.
The following were prominently found to be fraudlent ways which firms use to recognize revenue before it is earned: recognizing revenue immediately after shipping stock to resellers, duplication of bills, re-invoicing of past due receivables so as to improve age of the receivables, creation of fictitious bills and customers, re billing of sales expected to be made in future, overstating percentage of completed work in contract accounting as well as leaving accounting books open at the end of financial period among other ways.
Auditors should carefully scrutinize proper revenue recognition in case it detects the following: Firstly, attractive commission offered to sales staff who attain given targets because such commissions may motivate them to manipulate sales revenue records. Secondly, when books of account show it is highly probable that the firm will not pay back its loans because it is likely that the management may misrepresent revenue to indicate that the organization is credit worth. Third, unusually high sales volume towards end of the year which may be manipulated so as to maintain sales made in previous years and finally loss of major clients may make management to manipulate sales to create a false image that everything is alright.
The stakeholders who will be influenced or who are affected by this misrepresentation of revenue i.e. improper recognition of revenue and expenses are the management, owners of the firm, potential investors ( those who may buy the firm’s shares) and financiers such as banks.
It is unethical for the president to encourage misrepresentation of financial information because it breaches international financial and reporting standards which requires financial information to give a true and fair picture of firms’ performance. First and foremost, the president is unethically discouraging recording of expenses in accrual basis. This makes him to further contravene the requirement of associating the expense of the year to its loss. It is therefore clear that the president is keen to misrepresent financial information with aim of giving a false picture which will prevent the firms’ share market price from falling. On the other hand Diane action of dating the adjusting entries December 31 is also unethical. This is because she actually knows that this is not the date which the transaction took place she therefore contravenes both accrual recognition principle as well as the prudence accounting concept.
Diane cannot accrue revenues and defer expenses and still be ethical because her action will not give true and fair financial information as required by international financial and reporting standards (IFRS). This is because revenue for the year will not be accompanied the entire year expense. However, the company can change its accounting policies and indicate this in notes accompanying financial information. It will however require the company to show how this change has affected the firm’s income for the year. Diane will have to prepare financial records using the previous accounting policy as well as the current one so that users of financial information can have true and fair view of financial performance of the company as required by IAS as well as IFRS for her to be ethical.
Reference
John M. and Rose M.2000. Improper revenue recognition: a problem for professionals. http://www.picpa.org/Content/cpajournal/2000/winter/9.aspx
