Essay questions 1. Explain what is meant by “Accrual Accounting” and “Cash-based Accounting”, giving an example...
1. Explain what is meant by “Accrual Accounting” and “Cash-based Accounting”, giving an example of a transaction and its handling under the two different accounting systems. (Chapter 3, Section 5.4.1 and in- class examples).
2. What is “Basic EPS” and how is it calculated? Is this number a good indicator for future company profitability? (Chapter 4, Section 6.2)
3. What is “Common-Size Analysis” of the Income Statement and why do we need it? (Chapter 4, Section 7.1)
1. The accrual basis of accounting is the concept of recording revenues when earned and expenses as incurred. The use of this approach also impacts the balance sheet, where receivables or payables may be recorded even in the absence of an associated cash receipt or cash payment, respectively.
Cash accounting is a type of accounting that focuses on cash inflow and outflows and therefore considers only the cash received during an accounting period as revenue and cash paid during the same period as expenses and accordinly prepare its Financial Statements.
Cash accounting Accrual accounting Recognizes revenue when cash has been received Recognizes revenue when it’s earned (eg. when the project is complete) Recognizes expenses when cash has been spent Recognizes expenses when they’re billed (eg. when you’ve received an invoice) Taxes are not paid on money that hasn’t been received yet Taxes paid on money that you’re still owed Mostly used by small businesses and sole proprietors with no inventory Required for businesses with revenue over $5 million
Accrual Bases Accounting example, an account receivable. In other words, a company receives a mobile phone bill in January for a past period (December of the previous year), this would be recorded as an expense accrual. Revenue: when services or goods have been provided by the company, but payment has not yet been received.
Cash Based accounting Example:- if Company ABC would sell its finished products of $100,000 in cash and another $100,000 in credit! According to cash basis accounting, only $100,000 would be recorded as cash revenue and not another $100,000 which was sold on credit. If we look at the accrual basis of accounting, $200,000 would be recorded as the revenue of the company
2. Basic EPS: A company's basic EPS, or basic Earnings Per Share, is the company's profits divided by the number of shares outstanding. This is usually calculated on both an annual and quarterly basis.
For example, if the company had earnings of $500 million and had 250 million shares of stock issued and outstanding, its basic EPS would be $2.00, because $500 million profit divided by 250 million shares = $2.00
Why Basic EPS and Diluted EPS Are Important to New Investors
EPS is a very important financial metric when it comes to analyzing the financial performance of a company. Many conservative investors rely on basic EPS information to calculate how much they think a stock is worth. Specifically, EPS forms the basis of several important financial ratios including:
a. The Price-to-Earnings Ratio or P/E Ratio
b. The PEG Ratio: The price-to-earnings growth ratio
c, The Dividend-Adjusted PEG Ratio:
3. Common size, or vertical analysis, is a method of evaluating financial information by expressing each item in a financial statement as a percentage of a base amount for the same time period. A company can use this analysis on its balance sheet or its income statement.
A balance sheet summarizes the company's assets, which are things that it owns that have value; its liabilities, which are the amounts it owes to others; and its equity, which is an owner's investment in the business. An income statement shows the company's revenues, which is the amount of money it made by selling its goods and services, and its expenses, which is the amount of money it spent to earn its revenues.
The formula used in common size analysis is:
Common Size Amount = (Analysis Amount / Base Amount) x 100%
The base amount will change depending on whether the company is completing its analysis on the balance sheet or the income statement. If the company completes its analysis on the balance sheet, then the base amount will be total assets or total liabilities and owners' (or shareholders') equity. If the income statement is used, the base amount will be net sales.