Accrual and Cash Basis Accounting Commercial accounting and generally accepted accounting principles, generally prescribe the accrual basis of accounting over the cash basis. Describe both bases of accounting and explain the differences. Cash basis is used mostly by small businesses where owners and creditors want a simple way to understand the financial statements. Cash basis is used when a company or creditors does not worry about the accuracy of the statements but just want to understand if there is profit or loss in the company. Revenues are recorded when cash is received and expenses are recorded when cash is payment.
Ratios can tell if the business is using its assets appropriately, and if liabilities of the company are well-managed. It shows whether a business can invest in more capital, or if there is room for business growth. It shows whether a business will be able to pay off its debts or their short-term expenses or their daily expenses. It basically shows the strength and weaknesses of the business. It helps for forecasting on making certain financial decisions.
Discuss the advantages and the limitations of “ratio analysis” There are several advantages and limitations of accounting ratios, I will address some of the key ones in this section Advantages * Accounting ratios can be used by investors to make decisions on whether or not to invest in a company or sell existing shares. * Accounting ratios can be used by management to give an indication of a company’s financial health i.e. is the company profitable? Can they meet creditor obligations? Are stock levels being efficiently managed?
Generally accepted accounting principles prescribe the accrual basis of accounting over the cash basis of accounting. The accrual basis of accounting measures the performance of a business by showing in detail every transaction regardless of when the funds are received. Cash basis of accounting only accredits earnings and expenses when money is really being paid out or received. The cash basis of accounting is a less expensive way of keeping records but the failure of using this method is that financing is very difficult because of inaccuracy. The big difference between accrual and cash basis of accounting is when one uses cash basis entries are recorded at the time payment is received.
Accrual basis on accounting is the method of accounting that most business and professionals are required to use by law because of its matching principles. It provides better picture of a company’s profits during an accounting period. Cash basis accounting is a very simple form of accounting. In cash basis accounting, revenues are recorded when cash is actually received from customers and expenses are recorded when they are actually paid, no matter when they were actually invoiced. According to "Accrual" (2012),” Cash-basis accounting does not recognize promise to pay or expectations to receive money or service in the future, such as payables, receivables, and prepaid expenses”.
Accrual basis accounting records the transaction immediately in a type of account, such as accounts payable, money owed to other companies for services; or accounts receivable “money owed by its debtors” ("Google.com", 2012). Later when the business pays out or is paid; they perform a balance by debiting one account and balancing by credit the corresponding and opposite account. Tracking the relationship between purchase and sale easier, something cash basis accounting fails at. In general, accrual basis accounting is preferred at tax time and for medium to large business. The classic example is expense.
This can make the financial statements misleading. Both methods are way of recording transactions the only difference is when the number hits a company’s bottom line. An account may use the cash basis accounting when the company’s is small and the books are kept on the actual flow of cash coming in and out. This is used normally with a company with no inventory or a sole proprietor. They typically use this method because it requires fewer journal entries for closing an accounting period and creating financial statements.
The vertical analysis of the income statement reports amounts as a percentage of sales. The restated amounts are known as a common-size income statement, horizontal analysis concentrate more on the reported numbers on the financial statements over the past years. The Balance Sheet and the Statement of Income are very important, but they don’t provide enough information for a financial management. The Ratio Analysis in financial statements is to analyze progress of the business. Ratio Analysis enables managers to compare its performance and condition with the average performance of similar businesses in the same industry.
When examining the balance sheet of a typical company you would see categories such as inventory, accounts payable, or accounts receivable, in a commercial bank balance sheet under assets you would find areas like loans and investments, and under liabilities you would find categories such as deposits and borrowings. This is a large factor in which separates the final statements of commercial banks and the final statements of your everyday company. Commercial banks accept various types of deposits from their clients; they then provide those funds to borrowers such as homeowners and small businesses, in which they can receive interest on these loans. They gain profit from the difference between the rate they pay for funds and the rate that they receive from the borrowers. The goal of the bank is to create a flow of funds so from the many deposits, the bank can lend out to a wide variety of borrowers and this creates the flow of funds, which is crucial in the banking system.
* WACC is the weighted average cost of capital. WACC will tell investors and lenders what the opportunity cost of investing is. Most people who calculate WACC will not get the same WACC because people interpret financials difference and look at the valuation differently. Even though it is calculated differently it is important that investors know what WACC means when they see it in an analysis so they know it is the opportunity cost. WACC is the minimum return required by the investors * As I said in the last bullet there are many different to interpret the numbers in WACC and the way Cohen did it is one way but there is different ways to interpret the data given.