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 doesn’t 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 problems.”
Required: Draft a memo to Mr. Pitt providing an explanation of why the bank requests accrual-based financial statements for loan requests such his. Include in the memo:
- An explanation of the difference between a cash basis and an accrual basis measure of performance than net operating cash flow.
- Why, in most cases, that accrual basis net income provides a better measure of performance than net operating cash flow.
- The purpose of adjusting entries as they relate to the difference between cash and accrual accounting.
Read a selection of your colleagues’ postings.