Question

You are a staff accountant at Reimer & Company, a small public accounting firm. One of the firm's partners, Leona Reimer, has asked you to deal with a disgruntled client, Mr. Robert Ramsey, owner of the city's largest clothing store. Mr. Ramsey is applying to a local bank for a substantial loan to remodel his store. The bank requires accrual based financial statements, but Mr. Ramsey has always kept the company's records on a cash basis. He does not see the purpose of accrual-based statements. His most recent outburst went something like this: "After all, I collect cash from customers, pay my bills in cash, and I am going to pay the bank loan with cash. And, I already show my building and equipment as assets and depreciate them. I just don't understand the problem." Required: In your position as a staff accountant at Reimer & Company, prepare a memo to Mr. Ramsey, the client, and include the following: 1. Explain the difference between a cash basis and an accrual basis measure of performance. 2. Describe why, in most cases, accrual basis net income provides a better measure of performance than net operating cash flow. 3. Explain the purpose of adjusting entries as they relate to the difference between cash and accrual accounting

Answer 1

Difference between a Cash basis and an Accrual Basis:

Accrual basis and Cash basis are two methods of accounting used to record transactions

The key difference between the two methods is the timing in which the transaction is recorded. Over time, the results of the two methods are approximately the same.

The cash basis of accounting records revenues when cash is received and expenses when cash is paid out. The cash method is also beneficial in terms of tracking how much cash the business actually has at any time; you can look at your balance and understand the exact resources at your disposal.

The accrual basis of accounting records revenues when they are earned and expenses when resources are used. The upside is that accrual basis gives a more realistic idea of income and expenses during a period of time, therefore providing a long-term picture that cash accounting can't provide.

The accrual basis of income provides a better measure of performance than net operating cash flows:

In most cases, the accrual basis provides a better measure of performance in the way in which the revenues and expenses are recognized.

Cash basis accounting recognizes income when cash comes in. So that a cash basis may not show an accurate reflection of your economics.

.Accrual accounting will:

• Match the revenue with expenses
• Show true economics
• Avoid the management manipulation of cash flow to influence the financial statements.
• Keep track of resource flow as well as cash flows

Accrual basis accounting provides accurate Profit and Loss's

So for a better view of profitability use the accrual basis of accounting.

Purpose of adjusting entries as they relate to the difference between Cash and Accrual basis:

Companies using a cash basis do not have to prepare any adjust entries unless they discover they have made a mistake in preparing an entry during the accounting period.

In the accrual basis of accounting, The main purpose of adjusting entries is to update the accounts to conform with the accrual concept. At the end of the accounting period, some income and expenses may have not been recorded, taken up, or uploaded; hence, there is a need to update the accounts.

If adjusting entries are not prepared, some income, expense, asset, and liability accounts may not reflect their true values when reported in the financial statements. For this reason, adjusting entries are necessary.

Types of Adjusting Entries

Generally, there are 4 types of adjusting entries. Adjusting entries are prepared for the following:

• .Accrued income-Income earned but not yet received
• Accrued Expense-expenses incurred but not yet paid.
• Deferred income-Income received but not earned
• Prepaid Expense-expenses paid but not yet incurred.