Question

Scenario: BizCon, a consulting firm, has just completed its first year of operations. The company's sales growth was explosive. To encourage clients to hire its services, BizCon offered 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 being paid cash on delivery. Also, it had to pay up front for 2 years of insurance. At the end of the year, BizCon owed employees for one full month of salaries, but due to a cash shortfall, it 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 the delayed wage payments.

Prepare the memo in a maximum 700 words including the following information to better outline the situation:

• 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 the 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 AND STAFF

FROM: CHIEF FINANCIAL OFFICER,

DATE: 10/05/19

SUBJECT: DELAYED WAGES

As you have already been informed, BizCon will be delaying paychecks due to current insufficient cash flows; I apologize for the inconvenience and we greatly appreciate your patience. I am aware there are questions pertaining to how BizCon reported a favorable net income but lacks sufficient cash to pay wages. I want to clarify the reasoning and assure all employees that BizCon had a great first year in sales performance and there is no need for concern; I have an explanation as well solutions to ensure this does not occur in the future.

There are two types of accounting methods: accrual and cash accounting. “Accrual-basis accounting means that transactions that change a company’s financial statements are recorded in the periods in which the event occur, even if cash was not exchanged…. Under cash-basis accounting, companies record revenue at the time they receive cash. They record an expense at the time they pay out cash (p. 153); here at BizCon we operate using accrual accounting.

With that said, there are a few reasons for the lack of cash flow: suppliers require cash payment upon delivery, the company pre-paid for an insurance policy for 2 years, and our 180-day financing offer to attract clientele. First, because this is BizCon’s first year of operations, we are considered a higher risk, therefore, suppliers and creditors expected cash payments upfront for supplies, equipment, and insurance; which affected our cash flow. Second, the most significant effects on the cash flow are the special offer of 180 days of financing. This offer to attract new clientele has placed us in a situation where cash flow is insufficient because this offer allows customers to receive our services without paying upfront; payment could take up to 6 months to receive.

This leads me to the main concern, high net income but no cash flows. Due to the accrual accounting method, when we sold our services to organizations that qualified for the special financing, we were required to record the transaction as Service Revenue; even though we did not receive payment. This caused an increase in revenue and net income when using the accrual accounting method, but not cash; because the payment was not or has not been received. With our performance and clientele from this year, I expect things to be different for the coming year.

In efforts to guarantee this does not occur again, I propose we only extend the special financing to smaller organizations to earn more clientele. In addition, customers currently using the offer will be required to schedule a payment date at their convenience; but this will allow us to have a more accurate cash flow. After a solid first year, BizCon should be evaluated as a less risky organization, which should open negotiations for payments to our suppliers and creditors. With these changes and continued success, BizCon will see significant improvements with cash flows.

Thank you for your patience and understanding but more importantly, thank you for your efforts and contributions this year!

Best Regards,

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