finance

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Difference between accrual basis and cash basis

Module 2 (Question 1)

The main difference between accrual basis and cash basis accounting is the time at which income and expenses are recognized and recorded. The cash basis method generally recognizes income when cash is received and expenses when cash is paid. The accrual method recognizes income when it is earned and expenses when they are incurred. Accrual accounting is more accurate in terms of net income because it matches income with the expenses incurred to produce it. It is also more realistic for measuring business performance. A business can be going broke and still generate a positive cash basis income for several years by building accounts payable, selling assets, and not replacing capital assets as they wear out. However, most small businesses use cash basis accounting because they do not understand the accounting principles that an accrual system requires, given the cost of hiring accountants to keep their records, accrual accounting is more expensive; and cash basis accounting is more flexible for tax planning. Valuation is the process of estimating the potential market value of a financial asset or liability. Valuations can be done on assets and on liquidation also. Accrual basis accounting is taking all revenue earned in a period and matching it with all expenses incurred during that exact period whether they have been paid for in cash or not. As an example of an accounting method that keeps financial accounting up to the minute, accrual basis accounting is perhaps the most commonly used approach to keeping up with income and expenses. Non-tax revenues are on an accrual basis of accounting, recorded in the period in which they are earned.

Module 2 (Question 2)

Filing for chapter 7 bankruptcy does not mean that immediately all of your debts are eliminated in their entirety. Rather, secured debt must be still be dealt with. It does mean, however, that commonly unsecured debts like credit card bills and medical expenses do not have to be paid back. But getting off the hook here does not come without costs. Rather, it often means the necessary liquidation of most of your personal property. While there are limitations to what can be confiscated by creditors, creditors will normally not show any respite. Because of the many drawbacks of bankruptcy, many individuals in need of debt relief look for other options. One such option is chapter 13 bankruptcy. It means quite simply that you are restructuring your debt by negotiating with your creditors and establishing a plan to pay them off over the course of three to five years. So, this is a formal declaration that you will and have worked with creditors so that they will get their money, only at a slightly slower rate than they might have wanted. By promising to pay off your debts, you are allowed to keep valuable personal property such as your home and car. Typically the arrangement reached with creditors is to have you pay your regular monthly payments, plus an additional amount that over time allows you to get caught up on your payments over time.

There are both benefits and costs to whichever bankruptcy approach you decide to take. On the one hand, filing Chapter 7 offers you the freedom to be rid of the heavy debt that is currently hanging over you, while Chapter 13 offers you only the chance to restructure that debt to be more manageable. But on the other hand, filing Chapter 7 also means the liquidation of almost all your valuables as well as the total devastation to your credit rating, whereas filing Chapter 13 allows you to keep many of your possessions while keeping your credit score intact.

Module 3 (Question 3)

The best approach to value two proposals with different total value is to use a contribution margin approach. However, it is not the only approach on which a production or sales decision should be made. In the example given Agent J’s proposal will result in a revenue of $100,000 whilst Agent K’s proposal fetches only $50,000. Using the contribution margin approach, Agent K’s proposal is way better because it provides a $600 contribution margin for each unit sold whereas that of Agent J fetches only $100 in contribution margin. This significant difference in the contribution margin overwrites the fact that Agent J’s proposal will result in a higher revenue. What is important in such a situation is to ignore both the contribution margin and the revenue approach and use another standard to make decisions – the profitability approach. Under this, the two proposals should be evaluated in terms of the total profit they will bring into the company. In this case, the breakdown is as follows:

Revenue

100,000

50,000

Variable Cost

95,000

38,000

Variable Profit

5,000

12,000

The result is clear here and indicates that Agent K’s proposal would yield a greater dollar amount of profit and thus is the better one. An added calculation of concern here is the profitability percentage: 5% for Agent J’s proposal and 24% for Agent K’s proposal. Calculations based on this approach will result in the best decision for a company that is seeking to optimize its profit-maximizing goals (Ibrahim, 2003).

Module 3 (Question 4)

FASB (Financial Accounting Standards Board) is a standards regulatory body whose mission is to maintain and enforce accounting standards for private sector institutions in order to improve the readability and scalability of financial statements across borders. Established in 1973, it provides a framework for accounting practices that other institutions can choose to follow and conform to in order to claim compliance with the FASB and present their financial performance according to the rules and regulations stipulated by the body (Atrill & McLaney, 2003). GASB (Governmental Accounting Standards Board) is the FASB equivalent for governments what the FASB does in terms of unifying reporting standards between institutions for investors’ ease and convenience is carried out by the GASB to bring governmental reporting to one benchmark for comparability. Again, seeking compliance with the GASB is not mandatory but doing so certainly increases the audience for governmental reporting and analysis.

Module 4 (Question 6)

The difference in rules governing the control of a debt estate between Chapter 7 and Chapter 13 bankruptcy led to this case in which Mr. Robert Marrama’s request for bankruptcy was dismissed as being “for cause” i.e. being done in bad faith. Mr. Marrama filed for Chapter 7 bankruptcy from his biggest debtor – the Citizens Bank of Massachusetts. However, seven months prior to doing so he had transferred a property of significant value to a newly created trust without any consideration. Further, he had misreported the value of the property and not disclosed the transfer he had made attributing it to business cause. However, the bank challenged him and then he decided to change his filing to Chapter 13 bankruptcy (QuizLaw GP, 2007). This was primarily because of the control of the debt estate differs between the two cases. Under Chapter 7 bankruptcy, the bank would have gotten control over the property (in Maine) whereas under Chapter 13 bankruptcy Mr. Marrama would have gained control over it. His conversion was rejected when he claimed that he was doing so because his lawyer had filed for Chapter 7 bankruptcy by mistake. His appeals were also turned down as a result of which his bankruptcy plea was rejected. The main reason as to why the court opposed the conversion even though it is allowed by the law was that he did not fit in the criteria needed for Chapter 13 bankruptcy – his property transfer actions were singly considered as bad faith incidents.

Module 4 (Question 6)

Change management is perhaps one of the most important and yet most feared activities in organizations. It becomes more significant especially when it comes to a change in accounting standards and the way in which financial transactions are recorded. If I were given the task of explaining to the CFO any significant change in accounting methodology to benefit the organization, I would explain this to them by beginning with the benefits. Since CFOs are high-profile people with limited spare time, I would commence the process of convincing them by using numbers to put forth the monetary benefits that may be realized by shifting accounting practices. Furthermore, I will provide handful comparisons of other organizations (mainly competitors) that would be using the proposed method of accounting in order to speed up the process of accepting the proposal. My approach is simple and direct and I would expect to get a much quicker response than by using the definitions approach.

Module 5 (Question 7)

The principle of relevance and materiality dictates that factors present in all alternatives cannot be relevant to the decision making process. Consider for example an inflow of cash on three different kinds of investment that has the same nature regardless of the investment kind. It therefore makes sense for us to reduce the decisions to their simplest differences by eliminating all the common factors (Ross, Westerfield & Jaffe, 2008). The law of the lowest common multiple applies pertinently to business decision making where the common multiples are chopped down in order to leave behind the factors that cannot be compared to each other since they lie on different footings. Thus, I completely agree with the statement and would end by saying that logically the approach saves a great deal of time in decision making and I have personally never come across a situation where not eliminating common factors/costs has cost the decision maker or including relevant costs made a difference to the final decision.


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