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Indeed, this is one of good area, where most of techies have lot of confusion and illusion about when accounting comes. Many of consultant came from Technical background and gradually moved into doing some techno -functional role or pure functional role, thus it is essestintial to understand the basic accounting and Guided principal .
Normally, there are two basic accounting methods available in the business world:
And most of the ERP accounting products weather its SUN system, Oracle financial or SAP have functionality to capture on the basis of set up.
Then want is the difference:
Cash Basis Accounting
This is what "Based on Realization"
We Most of us use the cash method to keep track of our personal financial activities.
The cash method recognizes revenue when payment is received, and recognizes expenses when cash is paid out.
For example, our local grocery store's record is based on the cash method. Expenses are recorded when cash is paid out and revenue is recorded when cash or check deposits are received
If we summarize, under the cash basis accounting, revenues and expenses are recognized as follows:
- Revenue recognition: Revenue is recognized when cash is received.
- Expense recognition: Expense is recognized when cash is paid.
Take a note the word "cash" is not meant literally - it also covers payments by check, credit card, barter, etc.
Moreover it is not standard method in compliance with accountings matching principle.
Accrual Basis Accounting
This is what "Based on Recognition"
The accrual method of accounting requires that revenue be recognized and assigned to the accounting period in which it is earned. Similarly, expenses must be recognized and assigned to the accounting period in which they are incurred.
Then the underline question is what is accounting Period, Let explain like this normally a company tracks the summary of the accounting activity in time intervals, which we normally called as Accounting periods. These periods are usually a month long. It is also common for a company to create an annual statement of records. This annual period is also called a Fiscal or an Accounting Year.
In the accrual method relies on the principle of matching revenues and expenses. This principle says that the expenses for a period, which are the costs of doing business to earn income, should be compared to the revenues for the period, which are the income earned as the result of those expenses. In other words, the expenses for the period should accurately match up with the costs of producing revenue for the period.
Take a case:
Company is doing a business and they have to pay sales commissions expense, so sales commissions expense should be reported in the period when the sales were made (and not reported in the period when the commissions were paid). Similarly, Salary/Wage to employees are reported as an expense in the week/month when the employees worked and not in the week/month when the employees are paid. If a company agrees to give its employees 2-month equivalent salary of its 2006 revenues as a bonus on January 25, 2007, the company should report the bonus as an expense in 2006 and the amount unpaid at December 31, 2006 as a liability. This is most simple kind of matching principal normally has.
In general, there are two types of adjustments that need to be made at the end of the accounting period.
- The first type of adjustment arises when more expense has been recorded than was actually incurred or earned during the accounting period.
- Similarly, there may be revenue that was received but not actually earned during the accounting period. Also known as Un-earned Revenue.
The accrual method generates tax obligations before the cash has been collected (because revenue leads to tax and revenue is recognized against receivable and not against receipt of money).
If we summarize, under the accrual basis accounting, revenues and expenses are recognized as follows:
- Revenue recognition: Revenue is recognized when both of the following conditions are met:
- Revenue is earned
- i.e. when products are delivered or services are provided.
- Revenue is realized or realizable.
- i.e. either cash is received or it is reasonable to expect that cash will be received in the future.
- Revenue is earned
- Expense recognition: Expense is recognized in the period in which related revenue is recognized (Matching Principle).
Timing differences in recognizing revenues and expenses
Various accounting books did mention four potential timing differences in recognizing revenues and expenses between these of two. Just to recap of those:
a. Accrued Revenue: Revenue is recognized before cash is received.
b. Accrued Expense: Expense is recognized before cash is paid.
c. Deferred Revenue: Revenue is recognized after cash is received.
d. Deferred Expense: Expense is recognized after cash is paid.
Compare with a Case to explain these two methods
Your company purchase a new Laptop on credit in May 2007 and pay $1,500 for it in July 2007, two months later.
Under the both case see how this makes a difference:
- Using the cash method accounting, you would record a $1,500 payment for the month of July, the month when the money is actually paid.
- Under the accrual method, you would record the $1,500 payment in May, when you take the Laptop and become obligated to pay for it.
Pros and cons of these Two accounting method
Maintence: 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, where as in the accrual method, you will typically record more transactions.
Cash-basis accounting defers all credit transactions to a later date. It is more conservative for the seller in that it does not record revenue until cash receipt. In a growing company, this results in a lower income compared to accrual-basis accounting.
Do you what is meant by GAAP?
No, I don't know, but knows most of ERP follows these. Lets explain this way:
The word"generally accepted accounting principles" (or "GAAP") consists of three important sets of rules:
(1) The basic accounting principles and guidelines,
(2) The detailed rules and standards issued by FASB(Financial Accounting Standards Board and its predecessor the Accounting Principles Board (APB)
(3) The generally accepted industry practices.
Normally Standard GAAP will have various guided Principal, such as
- Economic Entity Assumption
- Time Period Assumption
- Cost Principle
- Matching Principle
- Revenue Recognition Principle
Will take a seprate case of some of them to understand in better way.
If you want to know more about GAAP, weather US-GAAP, UK-GAAP , refer wikipedia
Oracle Financials have been developed to meet GAAP requirements as well as the special needs of different countries. For example, in Oracle Payables you can choose whether to record journal entries for invoices and payments on an accrual basis, a cash basis, or a combined basis where accrual journal entries are posted to one set of books and cash basis journal entries are sent to a second set of books.
Will continue with some additional accounting stuff, keep reading and commenting.