Veto Rights – Meaning and its Importance
The process of negotiations between startup companies and investors is often hotly debated and contested. There are several points of contention between the two parties. However, the two parties are often able to reconcile most of their differences. However, when it comes to controlling of the startup firm, both the startup founders as well as […]
How Changes in Interest Rates Affect Bonds ?
Interest rates are one of the most important factors while determining the bond value. All other factors like payments, number of periods etc are standard i.e. the numbers supplied to us are the numbers that have to be used in the formula for calculating present value. However, this is not the case with interest rates. […]
FAQ’s About Behavioral Finance
Behavioral finance is a fairly recent phenomenon. The development of this branch of finance is not more than a few decades old. This is the reason why there is still a lot of ambiguity about behavioral finance. Investors still have a lot of questions about behavioral finance, which they would like to clarify. This is […]
What are Common Size Statements ?
Common size statements are not financial ratios. Rather they are a way of presenting financial statements that makes them more suitable for analysis. However, analysts always use them in conjunction with ratio analysis. In fact, financial analysts use common size statements as the starting point to help them dig deeper. Common size statements tell them […]
How do Pension Plans Work?
The main objective of the financial system is to allow the participants to meet their financial goals. One common goal which almost every financial system participant has is the goal of a comfortable retirement. Most people want to set aside certain sums of money in their productive years and invest this money wisely so that […]
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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An Overview of Contracts and Why They are Important to Business and Society
February 12, 2025
