The financial statements of Family Health Care for November were prepared under ac- crual accounting concepts. Entities that use accrual accounting concepts for recording transactions and preparing financial statements are said to use the accrual basis of accounting. The accrual basis of accounting is used by large businesses and is required of publicly held corporations such as Amazon.com,eBay, and Wm. Wrigley Jr. Company.
Entities that record transactions only when cash is received or paid are said to use the cash basis of accounting. Individuals and small businesses often use the cash basis of accounting.1For example, you probably use a cash basis because your checkbook is
1 Some businesses use modified-cash bases of accounting. These bases of accounting are covered in advanced accounting texts.
Describe how the accrual basis of accounting enhances the interpretation of financial statements.
5
Exhibit 7
Integrated Financial Statements—Family Health Care
Family Health Care Balance Sheet November 30, 2007
Assets ⴝ Liabilities ⴙ Stockholders’ Equity
Cash Capital Retained
Stock Earnings
• • • •
• • • •
• • • •
$7,730 $18,600 $11,000 $8,510
$38,110 $38,110
Total Assets Total Liabilities Stockholders’ Equity
⎫⎪⎪⎪⎬⎪⎪⎪⎭ ⎫⎪⎪⎪⎪⎪⎪⎪⎪⎪⎪⎬⎪⎪⎪⎪⎪⎪⎪⎪⎪⎪⎭
Reconciliation of cash flows from operations and net income (see appendix
to this chapter) Family Health Care
Statement of Cash Flows For the Month Ended Nov. 30, 2007 Operating act. $(1,690) Investing act. (1,700)
Financing act. 3,800
Increase in cash $ 410
Cash, Nov. 1 7,320
Cash, Nov. 30 $ 7,730
Family Health Care Income Statement For the Month Ended Nov. 30, 2007
Revenues $12,350
Expenses 6,320
Operating income $ 6,030
Other income 360
Net income $ 6,390
Family Health Care Retained Earnings Statement For the Month Ended Nov. 30, 2007
RE, Nov. 1 $ 3,320
Net income 6,390
Dividends (1,200)
RE, Nov. 30 $ 8,510
your primary accounting record. You keep track of your deposits (cash receipts) and checks (cash payments). Periodically, your bank sends you a statement that you use to verify the accuracy of your record keeping.
Using the Cash Basis of Accounting
Under the cash basis of accounting, a business records only transac- tions involving increases or decreases of its cash. To illustrate, assume that a real estate agency sells a $300,000 piece of property on December 28, 2006. In selling the property, the agency earns a commission of 8%
of the selling price. However, the agency does not receive the $24,000 commission check until January 3, 2007. Under the cash basis, the real estate agency will not record the commission (revenue) until January 3, 2007.
Under the cash basis, expenses are recorded only when cash is paid.
For example, a December cellular phone bill that is paid in January would be recorded as a January expense, not a December expense.
Thus, under the cash basis, the matching concept does not determine when expenses are recorded. That is, expenses are recorded when paid in cash, not necessarily in the period when the revenue is earned. As a result, adjusting entries are not required under the cash basis.
Using the Accrual Basis of Accounting
Under the accrual basis of accounting, revenue is recorded as it is earned, regardless of when cash is received. To illustrate, using the preceding example, the real estate agency would record the commissions (revenue) of $24,000 as earned on December 28, 2006, even though the check (cash) is not received until January 3, 2007. Once revenue has been earned and recorded, any expenses that have been incurred in gen- erating the revenue are recorded and thus matched
against that revenue. For example, a December cel- lular phone bill would be recorded in December as an increase in expenses and liabilities, even though it is not paid until January. In this way, the December phone expense is matched against the revenue it helped generate in December. We used the accrual basis of accounting to record the November transac- tions of Family Health Care. In addition, as we illus- trated earlier in this chapter, the accrual basis requires adjusting entries to update the accounting records at the end of the period. Exhibit 8 summa- rizes the basic differences of how revenue and ex- penses are recorded under the cash and accrual bases of accounting.
Q.On June 30, a lawyer billed a client for $4,000 for legal services provided during June. The client paid $1,500 in July and
$2,500 in August. Under the cash basis, when are the fees earned recorded?
A. June, $0; July, $1,500;
August, $2,500
©RYAN MCVAY/PHOTODISC/GETTY IMAGES ©STOCKBYTE PLATINUM/GETTY IMAGES
Cash Basis Accrual Basis
Revenue is recorded When cash is received When revenue is earned Expense is recorded When cash is paid When expense is incurred in
generating revenue
Adjusting entries Not required Required in order to prepare financial statements
Exhibit 8
Cash versus Accrual Accounting
Family Health Care Under the Cash and Accrual Bases of Accounting
All the transactions for Family Health Care in Chapter 2 involved the receipt or pay- ment of cash. As a result, the financial statements shown in Chapter 2 for Family Health Care would be the same as that reported under the cash basis of accounting. In this chapter, however, Family Health Care entered into transactions that used accrual accounting concepts. As a result, the November financial statements shown in Exhibits 3 through 6 differ from those prepared using the cash basis of accounting.
One of the major differences in financial statements prepared under the accrual and cash bases of accounting involves the reporting of net income and net cash flows from operations. Under the cash basis of accounting, net income and net cash flows from operations are the same. For example, in Chapter 2, net income and net cash flows from operations for September and October for Family Health Care were
$2,600 and $3,220. In contrast, under the accrual basis of accounting, net income and net cash flows from operations may be significantly different. This is shown in Exhibit 3 where Family Health Care reports net income of $6,390 for November while report- ing net cash flows from operations of ($1,690). This difference is due to the effects of accrual and deferrals.2
Importance of Accrual Basis of Accounting
The use of the accrual basis of accounting is essential for assessing and interpreting the financial performance of an entity. To illustrate, we have summarized the net cash flows from operations and net income for Family Health Care below.
Net Cash Flow
from Operations Net Income
September $ 2,600 $2,600
October 3,220 3,220
November (1,690) 6,390
Under the cash basis, the cash flows from operating activities and the net income for November would be reported as a negative amount (loss) of $1,690. While this might be interpreted as an unfavorable trend, the accrual basis better reflects what is really happening to Family Health Care. Since September, revenues have more than doubled, increasing from $5,500 to $12,350, and net income has more than doubled.
Thus, the accrual basis reflects Family Health Care as a profitable, rapidly expanding business. This illustrates why net income is generally a better predictor of the long- term profitability of a business than is net cash flows from operations.
Such differences between the cash basis and the accrual basis illustrate why gener- ally accepted accounting principles require the accrual basis for all but the very smallest businesses. You should recognize, however, that the net cash flow from op- erating activities is an important amount that is useful to readers of the financial state- ments. For this reason, generally accepted accounting principles require reporting cash flows. For example, in the long run, a business will go bankrupt if it continually
2 A formal reconciliation of net cash flows from operations and the net income is shown in the appendix at the end of this chapter.
experiences negative cash flows from operations, even though it may report net in- come. In other words, a business must generate positive cash flows from operations in order to survive. In the case of Family Health Care, the negative cash flows from operations for November was due in large measure to prepaying insurance premi- ums of $8,400. Thus, the negative cash flows from operations is temporary for Family Health Care and not a matter of major concern. This illustrates why the fi- nancial statements must be analyzed and interpreted together, rather than individ- ually and why we use the integrated financial statements approach throughout this text. For example, long-run profitability is best analyzed by focusing on the net in- come reported under the accrual basis, while the availability of cash to pay debts as they become due is best analyzed by focusing on the net cash flows from operating activities.