Advanced Accounting

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Question:

You have recently been hired by Davis & Company, a small public accounting firm. One of the firm’s partners, Alice Davis, has asked you to deal with a disgruntled client, Mr. Sean Pitt, owner of the city’s largest 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’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.”

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Draft a memo to the client to explain the importance of accrual based financial statements, make sure you: explain the difference between a cash basis and an accrual basis measure of performance, describe why, in most cases, accrual basis net income provide a better measure of performance than net operating cash flow, and explain the purpose of adjusting entries as they relate to the difference between cash and accrual accounting.

Answer:

To: Mr. Sean Pitt

From: Research Analyst of Davis & Company

Date: 01/03/2017

Re: Importance of Accrual Based Financial System over Cash Based Financial System

Context Line

It is true that for operating a business efficiently, cash is the best alternative as this is the simplest and faster way for saving money. However, when a business is ran by “cash” only, the business comes with downsides. It has been found that for lending money, a bank looks after the consistency of the business within its client’s finances in order to better detect the involved risk.       

Action Line

The particular information can be gathered by the financial institution through two methods – “cash based” and “accrual accounting”. The hardware store of the particular client follows cash based accounting, thus, it does not possess a way for showing the amount earned or lost by the business, as this method does not maintain any record (Saunders & Cornett, 2014). Therefore, the cash based method creates a difficulty in lending money with the bookkeeping methodology. Therefore, it can be said that implementation of the accrual based financial statements is important for any business operation.      

Rest Of The Memo

It is a common factor that people pay advance for various things like rent, but cash based method does not provide an exact version of the loss or profit statement. This is the main difference between cash basis and accrual basis. The other difference include – cash method represents a circumstance like this – in one year an individual paid double rent, whereas, in next year he paid nothing. On the contrary, accrual method helps in keeping detail information regarding financial profits of the firm and its way of spending it (Christensen, Baker & Cottrell, 2014). Moreover, accrual method helps in presenting the whole year uniformly and gives an exact look of the company finances. Thus, it can be said that in most cases accrual basis net income provides better measure of performance than net operating cash flow. Therefore, this method assists the banks in lending money to the company as this method represents the financial statements of the firm clearly. Based on the status, the bank will lend money for renovation of the store and therefore, accrual accounting is considered as most useful method for any business.

References

Christensen, T. E., Baker, R. E., & Cottrell, D. M. (2014). Advanced Financial Accounting. The McGraw-Hill Companies, Inc.

Saunders, A., & Cornett, M. M. (2014). Financial institutions management. McGraw-Hill Education,.

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