Question

You have recently been hired by Jones & Co, a small public accounting firm as an internal auditor. One of the firm's partners, Joe Jones, has asked you to deal with an unhappy client. The client, Susan Swan, is the owner of the city's largest jewelry store, DiamondsRUs.

Ms Swan wants to remodel her store and is applying for $80,000 loan with Planters National Bank. The bank requires the use of accrual basis accounting for financial statements.  Ms Swan insists that she has always used cash basis accounting for her jewelry store. She does not see the purpose of using accrual basis accounting and refuses to make year-end adjusting entries.

Required:

Write a (friendly) email to Ms Swan to include the following:

1. Explain the main differences between cash basis and accrual basis accounting.

2. Explain what is the FASB and why it requires the use of the accrual basis accounting for financial external reporting.

3. Explain why year-end adjusting entries are necessary in accrual accounting.

Please use proper format. Your email should include an introduction and proper closing along with 2-3 paragraphs to explain the main points (1-3) above.   

Answer 1

Hi Ms Swan

Subject: An introduction to Accrual system of accounting and its Importance.

       I heard that you are dealing with some issues regarding adoption of Accrual basis of Accounting.

Let me first explain what are things that make Cash basis of Accounting different from Accrual basis of Accounting. In cash basis we record income or expenses when we actually receive or pay cash while on the other hand in Accrual basis we record income when we earn it and not when we receive cash against it, similarly we record expenses when expenditure is done and not when we actually pay for that. In Short Cash Basis of Accounting is not an Acceptable method of Accounting.

To make Financial statements true and correct it is necessary that GAAPs (Generally accepted accounting principles) are followed. FASB (Financial Accounting Standard Board) has given Various standards, principles and practices to make financial statements comply with GAAPs. One of the Principle stated by FASB is Revenue Recognition which states that transactions should be recorded when they occur and not when cash is exchanged. To follow the Principle of Revenue recognition it is necessary to record transaction on Accrual basis.

There are many expenses on which we pay the creditor after some time , in some cases even after end of the financial year. So if an expense is due but not recorded in books of account (when cash basis is adopted) and year has ended and we pay for that in next year which will be recorded as expense of next year , although in fact it relates to previous year.

Suppose a vendor makes account on cash basis and he has purchased inventory during the year which he recorded as an expenses in that year but at the end of year some stock has been left unsold. The Income statement will not show correct earning since closing stock is not recorded. Adjustment entry for closing stock has to be made in account to reflect true income. Another example could be payment received from customers. There may be some payments from customers received in advance which has to be recorded at the end of year as Unearned Income. In short Year end Adjustment Entries are very important to make financial statements true and correct.

To conclude it is necessary to Prepare Financial Statements using Accrual Basis of Accounting instead of Cash Basis.

"Hope you find this Information useful"

Thanks and Regards

Internal Auditor

C/O Jones and Co.