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The Cash Basis of Accounting

Chapter 2

Electronic Presentation by Douglas Cloud

Pepperdine University

Electronic Presentation by Douglas Cloud

Pepperdine University

2-2

1. Describe the basic elements of a financial accounting system.

2. Describe the cash and accrual bases of accounting.3. Use the cash basis of accounting to analyze,

record, and summarize transactions for a corporation’s first period of operations.

4. Use the cash basis of accounting to prepare financial statements for the first period of operations.

Learning GoalsLearning GoalsLearning GoalsLearning Goals

After studying this After studying this chapter, you should chapter, you should

be able to:be able to:

After studying this After studying this chapter, you should chapter, you should

be able to:be able to:

ContinuedContinuedContinuedContinued

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5. Use the cash basis of accounting for recording transactions and preparing financial statements for a second period of operations.

6. Describe the advantages and disadvantages of the cash basis of accounting.

7. Describe and illustrate how vertical analysis can be used to analyze and evaluate a company’s performance.

Learning GoalsLearning GoalsLearning GoalsLearning Goals

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1Learning GoalLearning GoalLearning GoalLearning Goal

Describe the basic elements of a financial accounting system.

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Balance SheetBalance SheetBalance SheetBalance Sheet

AssetsAssets = LiabilitiesLiabilitiesStock-

holders’ Equity

Stock-holders’ Equity

+

The rights of creditors

The rights of the stockholders

The The Accounting Accounting EquationEquation

The The Accounting Accounting EquationEquation

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Describe the cash and accrual bases of accounting.2

Learning GoalLearning GoalLearning GoalLearning Goal

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Under the cash basis of accounting, a business

records only transactions involving increases or

decreases in cash.

Under the cash basis of accounting, a business

records only transactions involving increases or

decreases in cash.

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Under the accrual basis of accounting, revenue is recorded as it is earned and an expense is

recorded when incurred.

Under the accrual basis of accounting, revenue is recorded as it is earned and an expense is

recorded when incurred.

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Use the cash basis of accounting to analyze, record, and summarize transactions for a corporation’s first period of operations.

3Learning GoalLearning GoalLearning GoalLearning Goal

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On September 1, 2003, Dr. Lee

Landry organized a professional

corporation to practice general

medicine.

On September 1, 2003, Dr. Lee

Landry organized a professional

corporation to practice general

medicine.

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a. Dr. Landry deposits $6,000 in a bank a. Dr. Landry deposits $6,000 in a bank account in the name of Family Health account in the name of Family Health Care, P.C. in return for shares of stock Care, P.C. in return for shares of stock in the corporation.in the corporation.

a. Dr. Landry deposits $6,000 in a bank a. Dr. Landry deposits $6,000 in a bank account in the name of Family Health account in the name of Family Health Care, P.C. in return for shares of stock Care, P.C. in return for shares of stock in the corporation.in the corporation.

Capital Stock 6,000 Investment by

Dr. Landry

Cash6,000 a.

Assets Stockholders’ Equity=

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b. Family Health Care borrowed b. Family Health Care borrowed $10,000 from First National Bank.$10,000 from First National Bank.

b. Family Health Care borrowed b. Family Health Care borrowed $10,000 from First National Bank.$10,000 from First National Bank.

Capital Stock 6,000

Cash6,000 a.

Assets

Stockholders’

Equity= Liabilities +

b. 10,000 10,000

Bal. 16,000 10,000 6,000

Notes Payable +=

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c. Family Health Care buys land for c. Family Health Care buys land for $12,000 cash.$12,000 cash.

c. Family Health Care buys land for c. Family Health Care buys land for $12,000 cash.$12,000 cash.

Capital Stock Cash

Assets

Stockholders’

Equity= Liabilities +

Bal. 16,000 10,000 6,000

Notes Payable +=

c. –12,000 12,000

Bal. 4,000 12,000 10,000 6,000

+ Land

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d. During the first month of operations, d. During the first month of operations, Family Health Care earns patient fees of Family Health Care earns patient fees of $5,500, receiving the amount in cash.$5,500, receiving the amount in cash.

d. During the first month of operations, d. During the first month of operations, Family Health Care earns patient fees of Family Health Care earns patient fees of $5,500, receiving the amount in cash.$5,500, receiving the amount in cash.

Capital StockCash + Land

Assets

Stockholders’

Equity= Liabilities + Notes Payable +=

d. 5,500 Revenue 5,500 Bal. 4,000 12,000 10,000 6,000

Retained Earnings

Bal. 9,500 12,000 10,000 6,000 5,500

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e. The expenses for the month were as follows: e. The expenses for the month were as follows: wages, $1,125; rent, $950; utilities, $450; wages, $1,125; rent, $950; utilities, $450; interest, $100; miscellaneous, $275.interest, $100; miscellaneous, $275.

e. The expenses for the month were as follows: e. The expenses for the month were as follows: wages, $1,125; rent, $950; utilities, $450; wages, $1,125; rent, $950; utilities, $450; interest, $100; miscellaneous, $275.interest, $100; miscellaneous, $275.

Capital StockCash + Land

Assets

Stockholders’

Equity= Liabilities + Notes Payable +=

e. –2,900 Wages expense –1,125Rent expense –950

Utilities expense –450Interest expense –100

Misc. expense –275

Retained Earnings

Bal. 9,500 12,000 10,000 6,000 5,500

Bal. 6,600 12,000 10,000 6,000 2,600

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f. Family Health Care pays $1,500 to f. Family Health Care pays $1,500 to stockholder (Dr. Landry) as dividends.stockholder (Dr. Landry) as dividends.

f. Family Health Care pays $1,500 to f. Family Health Care pays $1,500 to stockholder (Dr. Landry) as dividends.stockholder (Dr. Landry) as dividends.

Capital StockCash + Land

Assets

Stockholders’

Equity= Liabilities + Notes Payable +=

f. –1,500 Dividends –1,500

Retained Earnings

Bal. 6,600 12,000 10,000 6,000 2,600

Bal. 5,100 12,000 10,000 6,000 1,100

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The following apply to all The following apply to all types of businesses:types of businesses:

The following apply to all The following apply to all types of businesses:types of businesses:

1. The effect of every transaction is an increase or a decrease in one or more of the accounting equation elements.

2. The two sides of the accounting equations are always equal.

3. The stockholders’ equity is increased by amounts invested by stockholders and by revenues. It is decreased by expenses and dividends. Let’s visualize this.

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SSTOCKHOLDERS’TOCKHOLDERS’ E EQUITYQUITYSSTOCKHOLDERS’TOCKHOLDERS’ E EQUITYQUITY

Capital Stock Retained Earnings

Stockholders’ Stockholders’ InvestmentsInvestments

RevenuesRevenues ExpensesExpenses DividendsDividends

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Use the cash basis of accounting to prepare financial statements for the first period of operations.

4Learning GoalLearning GoalLearning GoalLearning Goal

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Fees earned$5,500

Operating expenses:Wages expense $1,125Rent expense 950Utilities expense 450Interest expense 100Miscellaneous expense 275 Total operating expenses 2,900

Net income$2,600

Family Health Care, P.C.Income Statement

For the Month Ended September 30, 2003

Revenue and expense amounts taken from the Retained Revenue and expense amounts taken from the Retained Earnings column in Exhibit 2 of the textbook.Earnings column in Exhibit 2 of the textbook.

Revenue and expense amounts taken from the Retained Revenue and expense amounts taken from the Retained Earnings column in Exhibit 2 of the textbook.Earnings column in Exhibit 2 of the textbook.

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Net income for September $2,600Less dividends 1,500Retained Earnings, September 30, 2003 $1,100

Family Health Care, P.C.Retained Earnings Statement

For the Month Ended September 30, 2003

The net income is taken from the income The net income is taken from the income statement (previous slide) and the amount of statement (previous slide) and the amount of

dividends from the Retained Earnings dividends from the Retained Earnings column in Exhibit 2 of the textbook.column in Exhibit 2 of the textbook.

The net income is taken from the income The net income is taken from the income statement (previous slide) and the amount of statement (previous slide) and the amount of

dividends from the Retained Earnings dividends from the Retained Earnings column in Exhibit 2 of the textbook.column in Exhibit 2 of the textbook.

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AssetsCash

$ 5,100Land

12,000Total assets

$17,100Liabilities

Notes payable$10,000

Stockholders’ EquityCapital stock $6,000Retained earnings 1,100

7,100Total liabilities and stockholders’ equity

$17,100

Family Health Care, P.C.Balance Sheet

September 30, 2003All account balances All account balances were taken from the were taken from the

bottom row of Exhibit 2, bottom row of Exhibit 2, except except Retained Retained

Earnings.Earnings.

All account balances All account balances were taken from the were taken from the

bottom row of Exhibit 2, bottom row of Exhibit 2, except except Retained Retained

Earnings.Earnings.

Retained EarningsRetained Earnings balance is taken from the balance is taken from the

retained earnings retained earnings statement.statement.

Retained EarningsRetained Earnings balance is taken from the balance is taken from the

retained earnings retained earnings statement.statement.

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AssetsCash

$ 5,100Land

12,000Total assets

$17,100Liabilities

Notes payable$10,000

Stockholders’ EquityCapital stock $6,000Retained earnings 1,100

7,100Total liabilities and stockholders’ equity

$17,100

Family Health Care, P.C.Balance Sheet

September 30, 2003

Total assets equal total liabilities Total assets equal total liabilities plus stockholders’ equity.plus stockholders’ equity.

Total assets equal total liabilities Total assets equal total liabilities plus stockholders’ equity.plus stockholders’ equity.

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Cash flows from operating activities:Cash received from customers $ 5,500Deduct cash payments for expenses 7,900Net cash flow from operating activities $ 2,600

Cash flows from investing activities:Cash payments for acquisition of land (12,000)

Cash flows from financing activities:Cash from sale of cap. stock $ 6,000Cash from notes payable 10,000 $16,000Deduct cash dividends 1,500Net cash flow from financing activities 14,500

Net increase in cash $ 5,100September 1, 2003 cash balance 0September 30, 2003 cash balance $ 5,100

Family Health Care, P.C.Statement of Cash Flows

For the Month Ended September 30, 2003

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Use the cash basis of accounting for recording transactions and preparing financial statements for a second period of operations.

5Learning GoalLearning GoalLearning GoalLearning Goal

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a. Received fees of $6,400 in cash.a. Received fees of $6,400 in cash.a. Received fees of $6,400 in cash.a. Received fees of $6,400 in cash.

Capital StockCash + Land

Assets

Stockholders’

Equity= Liabilities + Notes Payable +=

a. 6,400 Revenue 6,400

Retained Earnings

Bal. 5,100 12,000 10,000 6,000 1,100

Bal. 11,500 12,000 10,000 6,000 7,500

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b. Paid expenses in cash as follows follows: b. Paid expenses in cash as follows follows: wages, $1,370; rent, $950; utilities, $540; wages, $1,370; rent, $950; utilities, $540; interest, $100; miscellaneous, $220.interest, $100; miscellaneous, $220.

b. Paid expenses in cash as follows follows: b. Paid expenses in cash as follows follows: wages, $1,370; rent, $950; utilities, $540; wages, $1,370; rent, $950; utilities, $540; interest, $100; miscellaneous, $220.interest, $100; miscellaneous, $220.

Capital StockCash + Land

Assets

Stockholders’

Equity= Liabilities + Notes Payable +=

e. –3,180 Wages expense –1,370Rent expense –950

Utilities expense –540Interest expense –100

Misc. expense –220

Retained Earnings

Bal. 11,500 12,000 10,000 6,000 7,500

Bal. 8,320 12,000 10,000 6,000 4,320

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c. Family Health Care pays $1,000 to c. Family Health Care pays $1,000 to stockholders (Dr. Landry) as dividends.stockholders (Dr. Landry) as dividends.

c. Family Health Care pays $1,000 to c. Family Health Care pays $1,000 to stockholders (Dr. Landry) as dividends.stockholders (Dr. Landry) as dividends.

Capital StockCash + Land

Assets

Stockholders’

Equity= Liabilities + Notes Payable +=

c. –1,000 Dividends –1,000

Retained Earnings

Bal. 8,320 12,000 10,000 6,000 4,320

Bal. 7,320 12,000 10,000 6,000 3,320

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Fees earned $6,400Operating expenses:

Wages expense $1,370Rent expense 950Utilities expense 540Interest expense 100Miscellaneous expense 220 Total operating expenses 3,180

Net income $3,220

Family Health Care, P.C.Income Statement

For the Month Ended October 31, 2003To review the source of To review the source of this amount, click the this amount, click the green button below.green button below.

To review the source of To review the source of this amount, click the this amount, click the green button below.green button below.

Revenue

To review the source of To review the source of expenses, click the orange expenses, click the orange

button below.button below.

To review the source of To review the source of expenses, click the orange expenses, click the orange

button below.button below.

Expenses

2-30

Describe the advantages and disadvantages of the cash basis of accounting.

6Learning GoalLearning GoalLearning GoalLearning Goal

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The primary advantage of the cash basis of

accounting is its simplicity.

The primary advantage of the cash basis of

accounting is its simplicity.

2-32

The primary disadvantage of the cash basis is that

revenues and expenses may not be properly matched on the income statement.

The primary disadvantage of the cash basis is that

revenues and expenses may not be properly matched on the income statement.

2-33

Describe and illustrate how vertical analysis can be used to analyze and evaluate a company’s performance.

7Learning GoalLearning GoalLearning GoalLearning Goal

2-34

Statements can be compared by computing a percentage of each item

within a statement to a total within the statement.

Statements can be compared by computing a percentage of each item

within a statement to a total within the statement.

2-35

This type of analysis is called vertical analysis.

This type of analysis is called vertical analysis.

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Vertical AnalysisVertical Analysis——Balance SheetBalance SheetVertical AnalysisVertical Analysis——Balance SheetBalance Sheet

Assets:Cash and cash equivalents $ 307,785Short-term investments 25,450Accounts receivable 239,885Inventories 278,981Property, plant, and equipment 684,379Other assets 229,168TOTAL ASSETS $1,765,648

$307,785$1,765,648

17.4%

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Assets:Cash and cash equivalents $ 307,785Short-term investments 25,450Accounts receivable 239,885Inventories 278,981Property, plant, and equipment 684,379Other assets 229,168TOTAL ASSETS $1,765,648

$25,450$1,765,648

17.4%1.4

Vertical AnalysisVertical Analysis——Balance SheetBalance SheetVertical AnalysisVertical Analysis——Balance SheetBalance Sheet

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Assets:Cash and cash equivalents $ 307,785Short-term investments 25,450Accounts receivable 239,885Inventories 278,981Property, plant, and equipment 684,379Other assets 229,168TOTAL ASSETS $1,765,648

17.4%1.4

13.615.838.8

13.0100.0%

Vertical AnalysisVertical Analysis——Balance SheetBalance SheetVertical AnalysisVertical Analysis——Balance SheetBalance Sheet

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Liabilities:Accounts payable $ 91,225Dividends payable 42,741Income and other taxes payable 68,467Long-term liabilities 157,127Other liabilities 129,891 Total liabilities $ 489,451Stockholders’ equity: Total stockholders’ equity 1,276,197 TOTAL LIAB. & S.E. $1,765,648

$91,225$1,765,648

5.2%

Vertical AnalysisVertical Analysis——Balance SheetBalance SheetVertical AnalysisVertical Analysis——Balance SheetBalance Sheet

2-40

5.2%2.43.98.9

7.427.7%

72.3100.0%

Liabilities:Accounts payable $ 91,225Dividends payable 42,741Income and other taxes payable 68,467Long-term liabilities 157,127Other liabilities 129,891 Total liabilities $ 489,451Stockholders’ equity: Total stockholders’ equity 1,276,197 TOTAL LIAB. & S.E. $1,765,648

Vertical AnalysisVertical Analysis——Balance SheetBalance SheetVertical AnalysisVertical Analysis——Balance SheetBalance Sheet

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Vertical AnalysisVertical Analysis—Comparative —Comparative Balance SheetsBalance Sheets

Vertical AnalysisVertical Analysis—Comparative —Comparative Balance SheetsBalance Sheets

Assets:Cash and cash equivalentsShort-term investmentsAccounts receivableInventoriesProperty, plant, and equipmentOther assetsTOTAL ASSETS

17.4%1.4

13.615.838.8

13.0100.0%

2001

19.1%1.9

12.216.138.5

12.3100.0%

2000

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5.2%2.43.98.9

7.427.7%

72.3100.0%

Liabilities:Accounts payable

Dividends payable

Income and other taxes payable

Long-term liabilities

Other liabilities

Total liabilities

Stockholders’ equity: Total stockholders’ equity

TOTAL LIAB. & S.E.

Vertical AnalysisVertical Analysis—Comparative —Comparative Balance SheetsBalance Sheets

Vertical AnalysisVertical Analysis—Comparative —Comparative Balance SheetsBalance Sheets

2001

4.6%2.53.99.8

7.328.1%

71.9100.0%

2000

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Vertical Analysis—Income StatementVertical Analysis—Income StatementVertical Analysis—Income StatementVertical Analysis—Income Statement

Net sales $2,429,646Cost of sales 997,054Gross profit $1,432,592Selling and administrative exp. 919,236Operating income $ 513,356Other income (expense) 14,010Income before income taxes $ 527,366Income taxes 164,380Net income $ 362,986

100.0%

$997,054$2,429,646

41.1

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Net sales $2,429,646Cost of sales 997,054Gross profit $1,432,592Selling and administrative exp. 919,236Operating income $ 513,356Other income (expense) 14,010Income before income taxes $ 527,366Income taxes 164,380Net income $ 362,986

100.0%

$1,432,592$2,429,646

58.9%

Vertical Analysis—Income StatementVertical Analysis—Income StatementVertical Analysis—Income StatementVertical Analysis—Income Statement

2-45

Net sales $2,429,646Cost of sales 997,054Gross profit $1,432,592Selling and administrative exp. 919,236Operating income $ 513,356Other income (expense) 14,010Income before income taxes $ 527,366Income taxes 164,380Net income $ 362,986

100.0%41.158.9%

37.821.1%

0.621.7%

6.814.9%

Vertical Analysis—Income StatementVertical Analysis—Income StatementVertical Analysis—Income StatementVertical Analysis—Income Statement

2-46

Vertical Analysis—Income StatementVertical Analysis—Income StatementVertical Analysis—Income StatementVertical Analysis—Income Statement

Net salesCost of salesGross profitSelling and administrative exp.Operating incomeOther income (expense) Income before income taxesIncome taxesNet income

100.0%41.158.9%

37.821.1%

0.621.7%

6.814.9%

2001100.0%

42.157.9%

36.321.6%

0.722.3%

7.015.3%

2000

2-47

The EndThe End

Chapter 2Chapter 2

2-48

2-49

a. Received fees of $6,400 in cash.a. Received fees of $6,400 in cash.a. Received fees of $6,400 in cash.a. Received fees of $6,400 in cash.

Capital StockCash + Land

Assets

Stockholders’

Equity= Liabilities + Notes Payable +=

a. 6,400 Revenue 6,400

Retained Earnings

Bal. 5,100 12,000 10,000 6,000 1,100

Bal. 11,500 12,000 10,000 6,000 7,500

Return to income statement

2-50

b. Paid expenses in cash as follows follows: b. Paid expenses in cash as follows follows: wages, $1,370; rent, $950; utilities, $540; wages, $1,370; rent, $950; utilities, $540; interest, $100; miscellaneous, $220.interest, $100; miscellaneous, $220.

b. Paid expenses in cash as follows follows: b. Paid expenses in cash as follows follows: wages, $1,370; rent, $950; utilities, $540; wages, $1,370; rent, $950; utilities, $540; interest, $100; miscellaneous, $220.interest, $100; miscellaneous, $220.

Cash + Land

Assets

e. –2,900 Wages expense –1,370Rent expense –950

Utilities expense –540Interest expense –100

Misc. expense –220

Capital Stock

Stockholders’

Equity= Liabilities + Notes Payable +=

Retained Earnings

Bal. 11,500 12,000 10,000 6,000 7,500

Bal. 8,320 12,000 10,000 6,000 4,320

Return to income statement