Misconceptions about Personal Finance
The importance of financial planning at an individual and family level cannot be overstated. For years, people and even governments have been trying to inculcate this habit into the masses. However, they have found it difficult to do so. This is because there are several misconceptions related to personal finance, which are common among people. […]
Advantages and Disadvantages of Preferred Shares
In the previous article, we understood what preferred shares are and also paid attention to their characteristic features. In this article, we will take the conversation forward by understanding the pros and cons of investing in preferred shares. An analysis of the commonly stated pros and cons helps investors evaluate the use of preferred shares […]
Types of Securitizations in Sporting Franchises
Securitization is now becoming an integral part of the way in which international sporting franchises finance themselves. There is no doubt about the fact that securitization is on the rise in the sporting industry in almost every part of the world. This can be easily verified with statistics. However, it needs to be understood that […]
How do the Derivative Markets Function?
Derivative markets are unique kinds of markets where derivative instruments are traded. As we already know, derivative financial instruments are those financial instruments that derive their value from another underlying instrument such as stocks or bonds. Futures, forwards, options, and swaps are some of the commonly traded derivative instruments. Derivatives markets have certain special features […]
The Rise of Flat Tax
Governments all over the world generally levy graduated taxes on their population. This means that as the income being taxed increases, the tax rate also increases. Under a graduated tax structure, some amount of income is exempted from the tax. Then, there is a different tax slab, which becomes applicable as soon as the income […]
Cash Basis of Accounting uses receipts and payments of cash to record incomes and expenses. Therefore, under the cash basis of accounting, if a corporation makes salary payments of January, 3 months later in April, it will be considered as expenses in the month of April, since that is when the cash was paid. Also, if the same company pays advance salary for the month of May in April, then it will be considered as an expense for April.
Similarly, the time companies spend doing value addition to their products, shows up in the books as expenses. Only when sale is closed and cash comes in the door, is income recognized. Cash basis of accounting considers advance payments as income since the cash has been received.
There are obvious problems with cash basis of accounting. They are as follows:
It is not uncommon for firms to negotiate trade credit for themselves. Under the terms of trade credit, firms use raw materials over a period of time and then make one lump sum payment for the use. Under the cash basis of accounting, all expenses appear on the financial statements at one go when the payment is made. This clutters expenses on the financial statements.
Just like we use credit from our suppliers, the firms that deal with us also tend to use our credit. They also make our payments in one lump sum. Therefore just like the expenses, the income also tends to be cluttered.
Under the cash basis of accounting, there will be no or very little income and expenses in some months and very large income and expenses in some others. This will be because of the cluttering effect. As a result, the financials become unpredictable.
On the other hand, accrual basis of accounting, recognized income when it is earned and recognizes expenses when they are incurred:
We use a combination of cash and accrual basis of accounting. The profit and loss account and balance sheet are prepared as per accrual basis while the cash flow statement tells about the cash situation of the firm.
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