Judgment Case Analysis: Cash vs. Accrual Accounting and Disclosure Requirements in Financial Statements
This paper analyzes the differences between cash and accrual accounting methods and the related disclosure requirements in financial statements.
Lily Green
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Judgment Case Analysis: Cash vs. Accrual Accounting and Disclosure Requirements inFinancial StatementsJudgment Case 2-1 (page 109)You have recently been hired by Davis & Company, a small public accounting firm. One of the firm’spartners, Alice Davis, has asked you to deal with a disgruntled client, Mr. Sean Pitt, owner of the city’slargest hardware store. Mr. Pitt is applying to a local bank for a substantial loan to remodel his store.The bank requires accrual based financial statements but Mr. Pitt has always kept the company’srecords on a cash basis. He does not see the purpose of accrual based statements. His most recentoutburst went something like this: “After all, I collect cash from customers, pay my bills in cash, and I amgoing to pay the bank loan with cash. And, I already show my building and equipment as assets anddepreciate them. I just don’t understand the problem.”Required:1.Explain the difference between a cash basis and an accrual basis measure of performance.2.Why, in most cases, does accrual basis net income provide a better measure of performancethan net operating cash flow?3.Explain the purpose of adjusting entries as they relate to the difference between cash andaccrual accounting.Judgment Case 2-1Requirement 1Cashbasisaccountingproducesameasureofperformancecallednetoperating cash flow. This measure is the difference between cash receipts and cashdisbursements during a reporting period from transactions related to providinggoods and services to customers. On the other hand, the accrual accounting modelmeasuresanentity’saccomplishments(revenues)andresourcesacrifices(expenses) during the period, regardless of when cash is received or paid.Requirement 2In most cases, the accrual accounting model provides a better measure ofperformance because it attempts to measure the accomplishments and sacrificesthat occurred during the year, which may not correspond to cash inflows andoutflows.