Hi, I'm Ray Sheen.
I'd like to talk with you about two fundamental elements of business financial
transactions.
That is amount and timing.
These two essential attributes are how we characterize a financial transaction.
Let's discuss those two aspects.
They have a major implication for financial reporting,
because of the time dependency associated with financial reports.
The first thing to understand is that they are equally important.
The date is just as important as the amount.
By amount, I mean the actually monetary value of the transaction.
This is normally expressed in terms of dollars, Euros, Yen, Rupees, Pesos,
whatever currency you're operating with.
The timing is the date on which the transaction occurs.
In financial reporting, the date is just as important as the amount.
That's because financial reports and financial statements are time based.
They're either for a period of time, or prepared for a particular date.
So, depending upon the date of the transaction, it may or
may not be included within the report.
Managers will often find it's easier to manage the date of a transaction
than the amount.
Since it's so important that we manage the timing of transactions,
we need to understand how the date for transaction is set.
Is it when we agree to the transaction?
Is it when we get control of what we are buying, or
lose control of what we are selling?
Is it when the bill is paid?
Granted, sometimes these are the same date, but
many times in business they are not.
We need to be clear which of these dates we are to use.
There are two methods that can be used to set the timing.
One of these methods is the cash basis, and the other is the accrual basis.
The cash basis sets the date based on when money changes hands.
This is the normal approach of a typical consumer who is out shopping.
The transaction occurs when I go to the store, select a pair of shoes, and pay for
them in the store.
Likewise, when I fill up my car with fuel, I pay the attendant, and
that is the date of the transaction.
The other method is the accrual method.
In this approach the date used for
the transaction is the date when the legal title or control of an item occurs.
The transaction date is based upon gaining or losing control.
For instance, when purchasing, is when a buyer gets access to the material
that the supplier's providing, or receives the benefit of the supplier's work.
It's not when they pay the bill.
The bill may not be paid for another 30 days, but the buyer has control of
the material, so the financial records would record it as a purchase.
Likewise for selling.
The date used in the accrual method,
is when the seller ships the product to the customer.
At that time the seller no longer has control, the customer does.
As you can imagine the difference in dates can have a significant impact.
If the customer doesn't pay for 30, 60 or
90 days, the transaction could be recorded in different quarters, or
possibly even different years, depending upon which method you use.
So under what conditions would we use the cash basis?
The cash basis is going to provide a clearer understanding of how much money
a company actually has available.
It focuses on the liquidity of the business.
This approach is often used by small family businesses or retail operations.
The management determines what they can and
can't do based upon how much cash is in the cash register.
Every night at the end of the work day, they add everything up.
What they sold, and what they spent that day, and then decide whether they're going
out for steak dinner, or going home for mac and cheese from a box.
So why would a business use the accrual method?
Because it is normally a better indication of how well the business is running.
The accrual basis will match benefits with costs.
The business receives raw material during a month.
Employs a workforce to make a product with that material during the same month, and
then sells the product at the end of the month.
The accrual method shows how profitable those efforts were.
Without the accrual method, the financial records could easily show
that the company has lost a lot of money in one month, if they paid for
materials and labor but did not get the benefit of the sale.
At the same time, it could show a tremendous profit if it recorded the sale
and did not pay the suppliers.
The company's records could become badly skewed by one or two late payments.
There are numerous reasons why payments do not happen at the time of the transfer
of the physical control of an an asset.
Especially if you're doing business internationally.
The accrual method is immune to all of them.
Whether it's a delay paying a supplier, or delay in receipt of the payment from
the customer, the accrual method still allows the company to line the costs and
benefits for their activities.
The accrual basis provides a much truer and
clear picture of the profitability of the business activity.
For that reason almost all major corporations use the accrual method.
So let's quickly review.
Every financial transaction has two equally important attributes,
amount and timing.
It is the timing which determines whether or
not a transaction should be included within the financial reports.
Most companies use the accrual method for setting the timing.
That means timing is based upon when control transfers,
not when money transfers.