Purpose: To help you understand the importance of cash flows in the operation of
ID: 2566983 • Letter: P
Question
Purpose: To help you understand the importance of cash flows in the operation of a small business. It’s the end of the month, and cash flow has been a little slow, as it usually is during this time of the accounting period. It just seems to be a little slower this month. You know that Wednesday the 31st is payday, which always requires a large cash outlay. However, you also know that your bank is looking for a set of financial statements as of the end of the month because the loan on your building is coming up for renewal soon. Based on some of the previous meetings with your bankers, they are always concerned with the cash balance, so you want to have your cash balance as high as possible. You come up with a tentative plan you believe will not only preserve some of your cash balance at the end of the month but also will help your bottom line, your net income. That’s the other thing that the bankers are always concerned about. You don’t want to make any mistakes with your financial statements at this crucial point, so you decide to contact your CPA to run the idea by her. The conversation goes something like this: “Good morning, Sherry. This is Bill Conan from Conan Consultants, Inc. Our financial statements have to look really good this month because the bank is going to be scrutinizing them pretty closely for our pending loan renewal. I know that the two things they concentrate on are the cash balance and the net income. So, I’ve got a plan to help in both of those areas. I’m going to hold off paying my employees until after the first of the month. Plus, last month, I made a big insurance payment to cover me for the next six months, so I won’t need to show any insurance expense this month. Both of those will help my net income because I won’t be showing those expenses on my income statement. Plus, by not writing the paychecks until the first of the month, I’ll be helping to show a higher cash balance. It’s really only one day, but the bank won’t know that my cash balance should be lower. These certainly sound like some good ideas that would help with my situation, but just in case, I wanted to check with you to see what you thought. Any comments?” The first words out of the CPA’s mouth are “Bill, you know that your financial statements are prepared using the accrual basis of accounting.” Requirement 1. Complete the thought process of the CPA concerning Bill’s plan. What does she mean by the accrual basis of accounting? What effect will that have on the net income? Is Bill correct in his assessment of the big insurance payment he made last month covering the next six months? What effect will that have on the net income? And in regard to the last item, what about Bill’s plan to keep the cash balance as high as possible and his statement “the bank won’t know that my cash balance should be lower”?
Explanation / Answer
Accrual basis of accounting;
Accrual basis of accounting refers to the system of accounting in which all revenue and expenses are recognized in the income statement when they have been incurred. So under accrual basis of accounting cash receipt and cash payment is not important. Receipt and payment in cash is considered under cash basis of accounting.
Thus finally we can say that a system of accounting which consider incomes & expenses on the basis of their occurrence, is known as accrual basis of accounting.
What effect will that have on the net income?
Both system of accounting (cash basis and accrual basis) will show different amount of net income hence it is clear that if a firm is using accrual basis of accounting then its net income may be low or higher incompare to cash basis of accounting.
Under given case payment of six months premium will not be shown in income statement because as per accrual basis of accounting only related month’s insurance expenses can be shown as expense thus net income will be higher in compare to cash basis of accounting.
Now let’s take other point that is payment of salary & wages to employees. As per accrual basis of accounting, salary & wages of the employees will be recorded in the income statement as these accrued thus these expenses will reduce net income immediately on 31st of the month. But in case of cash basis salary & wages expenses will be recorded when these will be paid thus it is clear that net income under accrual basis will be low in compare to cash basis.
Is Bill correct in his assessment of the big insurance payment he made last month covering the next six months?
No, Bill is not correct because financial statements are being prepared as per accrual basis of accounting thus relevant insurance expenses must be recorded in income statement as they have been incurred.
It is possible only under cash basis of accounting because under this sysem expenses are recorded at the time of payment.
What effect will that have on the net income?
Net income will be reduced by the amount of actual insurance expenses consumed for the period because financial statements are being prepared as per accrual basis of accounting.
And in regard to the last item, what about Bill’s plan to keep the cash balance as high as possible and his statement “the bank won’t know that my cash balance should be lower”?
Yes it is possible because financial statement are being prepared as per accrual basis of accounting and it has no connection with cash payment. Thus by not writing the paychecks until the first of the month, I’ll be helping to show a higher cash balance. Although these expenses have been recorded in the income statement but cash balance is different aspect so inspite of recording these expenses in the income statement Bill can retain cash balance till the start of next month.
But as it is said that “bank won’t know that my cash balance should be lower” is not correct because bank can demand for cash flow statement and this statement will show real picture of the month. As we know that official of the bank also know the difference between cash basis and accrual basis of accounting so they definitely will check the impact of these conditions.
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