Question

Scenario
Bizcon a consulting firm has just completed its first year of operations. to encourage clients to hire its services Bizcon offered an 180 day financing meaning its largest customers do not pay for nearly 6 months. because BizCon is a new company, its equipment suppliers insist on bieng paid cash on delivery. also it had to pay up front for two years of insurance. at the end of the year BizCon owed employees for one full month of salaries, but due to cash shortfall I promised to pay them the first week of next year. As the senior Accountant , the Chief financial officer has asked you to prepare a memo to be sent to management notifying them of delayed wage payments.
prepare a 700 word memo including the following:
Explain how cash and accrual accounting differs for each of the events listed in the above scenario and describe the proper accrual accounting.
Assess how at the end of the year, BizCon reported a favorable net income, yet the company's management is concerned because he company is very short of cash. Explain to management how BizCon could have positive net income and yet run out of cash.

Answer 1

To: Management team of Bizcon

From: Chief Financial Officer

Date: January 11, 2019

Subject: Delayed Wages

Dear Sir/Madam

Considering we are new in the market, to raise market share, we have offered 6 months credit period to all our customers. Meaning thereby, at end of the year, we still have six months of sales to be collected.

On the other hand, because of same reason of new in the market, our vendors are not offering any credit period to us and we must pay them immediately on delivery of materials/services.

Above scenario has created short of cash crunch thought our Profit and Loss account is showing favourable net income.

As you all know that we are following accrual accounting concept, meaning thereby that every income we recognized once its accrue (whether collected or not) and every expense we provide for once its incurred (even if not paid).

Accrual concept is the most fundamental principle of accounting which requires recording revenues when they are earned and not when they are received in cash, and recording expenses when they are incurred and not when they are paid. We are following the same considering below things:

1. Under accrual concept of accounting, financial statements reflect all the expenses associated with the reported revenues for an accounting period. The usability of financial information is thus increased.

2. The departure from accrual concept ceases the ability of the users to compare the financial statements of an entity with that of others which ultimately results in less lucrative from investors’ point of view.

3. It makes financial information more accurate and more reliable.

Since we are recording income as accrued and expenses as incurred, our favourable net income is not being supported by cash position as we are falling short in cash.

Activity 1: Sales and Receivable: As per accrual accounting concept, we have recognized revenue immediately on accrual even thought cash will be received after six months. So this sale has increased our net income however, no increase in cash along with.

Activity 2: Equipment Supplier: Equipment is capital asset and will be reflected in balance sheet having no impact on Profit and Loss account (except depreciation) which is a non cash expense. However, payment for the equipment has been made immediately to supplier, bringing total cash down by the same amount.

Above explanation will help you to understand how can we have favourable net income and unfavourable cash balance. This is just because of accrual accounting concept.

What other accounts affected by accrual accounting:

Profits incorporate all business expenses, including depreciation. Depreciation doesn't take cash out of your business; it's an accounting concept that reduces the value of depreciable assets. So depreciation reduces profits, but not cash.

Inventory and cost of goods sold also affect profits, but not necessarily cash. For example, you have to buy products to put into inventory and pay for those products. That comes out of cash, and you might have a profit on the ultimate sale of that product, but in the meantime, you're still out the cash.

Profit and cash-flow are related financial measurements in accounting but they are not directly linked. Profit is a measure of an company's ongoing sustainability while cash-flow is a measure of the company's ability to pay its bills as they become due.

The discrepancy in the measures between profit and cash-flow is caused primarily by timing differences.

• To get an accurate picture of a company's profit, accounting only focuses on when the revenue is legally earned and expenses incurred (legally due), without regard to when the cash is actually exchanged. This is known as accrual accounting and is built on the matching principle (i.e. match the revenue earned with the expenses needed to earn that revenue)
• To get an accurate picture of a company's cash-flow, accounting only focuses on when the cash is actually exchanged (received or paid) with the legal obligations being extinguished. The profit aspect of when the revenue and expenses occurred, are not considered

Though its normal scenario on business to have favourable income and short of cash, but this position is not considered good in long term as it is affecting liquidity negatively.

Considering all above things, we are expecting cash in flow in first week of next months. Hence requesting you to postpone salaries payment to employees for a week.