Cash Basis Vs. Accrual Accounting

Accounting Re: Accounting Policies The company is facing a challenge where it does not have the cash needed to pay employee salaries. Although the company shows a profit, it has negative cash flow at present. Understanding how cash accounting and accrual accounting works will highlight how this situation has come to be. Cash accounting is accounting via cash flows which is a simple methodology, typically used by small business.

It is relatively easy to implement, but has a disadvantage of distorting the actual profitability of the company when the timing of cash flows are not aligned with the timing of events, something that is the case with BizCon (Accounting Tools, 2017). The 180 financing, for example, appears as revenue on the income statement (accrual) but the cash has not yet been received. The insurance that was purchased in advance is a cash flow, but the insurance is not reported in accrual accounting as having been purchased.

The cash goes down but the balance sheet shows prepaid insurance as an asset as well, so there is a slight distortion there in that the value of assets doesn't change, when via cash basis it would have because of the decrease in cash. The delayed wage payments are a current liability on the balance sheet in accrual accounting, and but would not show on the income statement yet.

This transaction also wouldn't show on cash basis either, but the reality is that it should be recorded as an expense. It is recommended that management looks at both cash flows and accrual accounting. There are advantages and disadvantages of both. Cash basis accounting is great for making sure that there are no cash flow problems, but it has the disadvantage of masking some of the items where the impact to the organization stretches over long periods of time, such as the 180 day credit or the 2 year insurance prepayment.

In contrast, accrual accounting is accepted under GAAP, aligns items with the time period of the impact to the organization, even over multiple quarters and years. But accrual accounting has the disadvantage, especially for more vulnerable companies, of potentially portraying a significantly different picture than what the cash flows portray – management is surprised that there is a cash flow problem here, because accrual accounting does not show that on the income statement (Wilkinson, 2014).

As such, the situation that BizCon now faces is that it owes wages, but lacks the cash to pay for them. The simple solution going forward is to reduce the credit that is offered. The company is too young, and its cash flow too precarious, to offer such generous terms as an incentive to its clients. The fact is that if those clients do not pay when the 180 days are up, this company will go out of business, if it does not do so before hand.

It is too small to extend credit; because BizCon is not a bank, it is not really in a position or have the expertise level to be a creditor, and should not do so just to win sales. Revenue is great, but cash keeps the lights on, or in this case, keeps the workers working. The current 180 day credit policy is at this point lending the workers' money to these customers, which isn't right.

The company needs bridge financing to get the wages paid, but after that it needs to end its crazy policy that delays cash flows by six full months from the time of sale; this is not affordable nor sustainable. The important concept to learn here is the cash conversion cycle. Right now, BizCon is paying for its supplies in cash up front, and then taking a minimum of six months to collect revenue from those supplies.

The cash conversion cycle should be much shorter, if this company is to have a viable business model. BizCon needs to start looking more at cash flow than at accrual accounting at this point. While both are valuable, for a young company with limited cash flow to look at accrual accounting for its strategic decision-making does not make sense, and is precisely.