Question

Why did the loan officer ask your brother whether he used the accrual basis of accounting for revenues and expenses? Why would it have been important to use this method?.

Answer 1

A loan officer would be concerned with the profitability of the brother's firm and its financial position. The profitability will determine the ability to service the loan and the financial position will determine the overall risk of the firm.

If the accounts were maintained on cash basis, the profitability so reported, will not reflect the total revenues and expenses for the period as it will not take into account the revenue earned but not received in cash and also the expenses incurred but not paid. Further, the revenues and expenses of earlier periods that were received in cash or paid in cash, during the current periiod, will affect the profit for the period.

Again, the balance sheet would not show accrued assets and liabilities, which is again a wrong presentation of the financial position. The true financial stability cannot be assessed from a balance sheet preparted on cash basis.

Hence, it is important for the lender to know the profitability and financial posittion on accrual basis. It is for that reason that the loan office enquired about the accounting being on accrual basis.