Financial Statements Essay

1352 words - 5 pages

Financial statements are significant for a business. They should provide information about the financial position, which is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions. (Kam, 1990, p34) Meanwhile, they are important to decision makers who use the financial information they provide to evaluate the performances of the firm and themselves. Thus, inaccurate financial statements may distort the portrayal of financial position and operating results of a business. For this reason, cash basis of accounting, as one of the accounting methods, is argued whether it is accurate and can be used in preparing financial statements or it is imperfect and may mislead the understanding of the financial statements by decision makers. However, in this essay, I will analyze that cash basis of accounting is defective and financial statements prepared on a cash basis of accounting may distort the portrayal of financial position and operating results of a business.Nowadays, there are two forms of accounting used by business, cash basis of accounting and accrual basis of accounting. The cash basis method of accounting is based on real-time cash flow. (Website: American Express Company, 2000, p1) In such method, you report an expense when it is paid, and record income when it is received. So expenses do not appear on the financial statements until they have been paid. So incomes do. With accrual accounting, you record income when it is earned, not when it is paid. Similarly, you record your expenses when the obligation arises, not when you pay it. (Website: American Express Company, 2000, p1) So the basic difference between the two methods is the timing of income and expense recording.For one business, financial information, especially income and expense, are extremely important. The net income of the business, which can be considered as the differences between income and expense, directly relates to that company's profit and loss. Therefore, different methods of accounting choosing in preparing financial statements will cause different results on that business's profit and loss reporting. Moreover, it will cause different further operations based on those different financial information by decision makers. In fact, comparing with the accrual basis method of accounting, the cash basis method of accounting will mislead the financial position of a business.One example, as J.H.White described in "Excerpt from Shirt-Sleeves Bookkeeping: The Problem with Cash Basis Accounting" (White, J, H, 1996) is that: for some businesses, cash basis accounting systems create a situation that leads to bankruptcy while, at the same time, reports the company is making a profit. Imagine one company has a project that uses several years. Its income is received prior to completion of the job, but its major costs are paid after the job is completed. In other words, the company receives money in a year prior to...

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