In China, foreign-invested enterprises are required to maintain a reliable records of accounts in accordance with Chinese accounting law and principles and submit tax filings on a monthly basis. The accounting principles are regulated by the People's Republic of Generally Accepted Accounting Principles (or PRC GAAP in short), also known as the Chinese Accounting Standards (CAS).
Although accounting is not a new profession, the fact that China's accounting system is relatively less mature than its counterpart found in developed economies and the country's continuous regulatory development, FIEs may experience challenges with compliance. Therefore, in this article we would like to explain the difference between accrual- and cash-based accounting and its relevance within Chinese Accounting Standards.
The basis of Cash- vs Accrual-based accounting
The main difference between cash- and accrual-based accounting lies in the timing at which sales and purchases are recorded in your accounts.
In a cash-based accounting system, the recognition of various revenue and expenses is based on actual receipt and payment (including cash and bank). All incomes and expenses which are actually received in the current accounting period shall be recorded, regardless of whether they belong to the current accounting period or not.
On the other hand, in an accrual-based accounting system the recognition of revenue and expenses in the current accounting period occurs on the basis of accrual rather than actual receipt. This means that all revenue and expenses which belong to the current accounting period shall be recorded and recognized regardless of actual receipt. This further implies that all revenue and expenses that do not belong to the current accounting period, even if they have been received, shall not be recorded as such in the current period.
The Limitations of Cash-based Accounting
Although accrual-based accounting is more complex than cash-based accounting, it provides a significantly better view regarding the company's position in terms of profits and losses. Furthermore, there are a number of limitations attributed to cash-based accounting which we would like to highlight below.
1. Lack of reflection on fixed assets
In cash-based accounting, the relevant expenses incurred when purchasing fixed assets will be listed in the corresponding expenditure accounts in the period in which they occur (are paid for). This expenditure is not capitalized (meaning they do not appear in the balance sheet after purchase) and is subsequently not included in the expenses for the remaining period within the service time of the fixed assets. Because the purchase of fixed assets is only recognized in the current period, you will incur an imbalance of expenditure in each subsequent accounting period.
Under this method the fixed assets are not depreciated, which means that the financial statements will only reflect the original value of the fixed assets. Because of the disregard of its net value, the assets are inflated, resulting in accounting information distortion.
2. Failure to accurately reflect liabilities
Furthermore, under cash-based accounting, liabilities are recorded when the monetary transaction is made and not in the period in which the obligation to undergo the liability has been made. For example, you agree with a supplier to complete a project in six months time and you have agreed to pay upon completion. This means that you have agreed to a payable, which will only be recorded upon payment in six months time.
While recording of such a liability by only the monetary transaction on the one hand is causing an imbalance of expenditure in each accounting period, more importantly on the other hand, the payable is not reflected in your financial statements and can lead to an incomplete budget, missing payment or cash flow difficulties. Furthermore, if the financial reporting does not reflect the implicit liabilities in time, this may result in poor decision-making and is not conductive for the prevention of financial risks.
3. Difficulty to conduct cost and expense accounting
Because the costs accounting content of an accounting system based on cash accounting is very simple, and cannot provide reasonable and complete cost data, it also cannot be a solid basis for decision-making, supervision and budget preparation for management personnel.
4. Incomplete accounting information
In general, financial statements which are prepared on the basis of cash accounting cannot fully reflect the company's assets, liabilities, financial results and cash flow. In term, this makes the financial information reflected in the accounting report incomplete, again resulting in risks to decision-making of the company.
The Chinese Accounting Standards
The purpose of accounting is to provide information required for sound economic decision-making. Here it is undeniable that the accrual-based accounting system plays an important role in ensuring that the accounting truthfully reflects the financial situation and operating results of an enterprise. For this reason the Chinese Accounting Standards stipulate that "accounting should be based on an accrual basis" for for-profit enterprises.
On the other hand, cash-based accounting has its advantages as well because it most accurately represents cash flow, meaning it draws an accurate picture regarding the amount of cash a company has on-hand.
In China, cash-based accounting is applicable to administrative/public institutions. It is also interesting to note that Representative Offices (ROs) in China also have to follow cash-based accounting. This means that Representative Offices keep their accounts according to legal and effective vouchers and perform accounting that is in accordance with the principle of matching actual functions performed and risks undertaken. It is important to note that Representative Offices are only allowed to conduct marketing and research activities for the overseas head office (and may not engage in commercial activities). For that reason, the taxable income of a Representative Office is calculated based on the company's actual expenses, over which enterprise income tax and value-added tax is calculated, and which is the reason to follow an accounting method on cash basis.
Although accounting on an accrual basis has its rationality when reflecting on the business performance of the company, it is also important to realize it has its own limitations when reflecting on the financial situation of the company. For example, an enterprise with good operations and high efficiency in the income statement can run into financial difficulties without corresponding cash flow in the balance sheet - which is caused by the fact that the accrual-based system reflects accrued revenues and expenses in the income statement, whereas it is recognized in the balance sheet partially as cash revenue and expenses, and partially as debt.
It is important for companies to be reminded of the limitations of their accounting method and potential additional (management) accounting reporting requirements. In the above example, a cash flow statement or statement of changes in the financial position on the basis of cash accounting could be prepared to compensate for the deficiency of the accrual-based system.
If you require more information or need support with the Chinese Accounting Standards, or require advise on your company's management reporting, you can read more about our Accounting Services or contact us at firstname.lastname@example.org.
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