What is Cost Modelling?
In the previous article, we have discussed how important revenue modeling is and the techniques which are used by companies to ensure that their revenue models are accurate and up to date. Once the revenue modeling is complete, the next step in the process refers to the modeling of expenses. This process is challenging because…
Functions of a Central Bank in Modern Economies
A central bank is an institution that is mandated by constitutional decree to function along certain principles and entrusted with managing the fiscal side of the country’s economy. The Fed Reserve and Bank of England are examples of central banks. These banks have many functions, some of which are listed below. The central bank manages…
Automated Intercompany Loans
Liquidity management can be a big problem for several companies. This is particularly true if the company has a large number of subsidiaries that are scattered in different places around the world. Companies that grow via the mergers and acquisitions route tend to face this problem more than other companies. This is because they often…
Banker’s Acceptance – Meaning, Advantages and its Disadvantages
In the previous articles, we have discussed some of the financial instruments which are commonly used in the money markets. However, most instruments are used for the purpose of domestic transactions. There is one money market instrument that stands out since it is widely used in order to finance international trade. In this article, we…
Three Dimensional Pscychographic Model
Psychographic models have evolved over the ages. They first began with the Bernwall model, which was a one-dimensional model. It later evolved into the BBK model, which was a two-dimensional model. Finally, in recent times, three-dimensional psychographic models have been developed. In this article, we will have a closer look at the three-dimensional model as…
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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