Chapter 2, Problem 2.1DMP

Judgment Case 2–1

Cash versus accrual accounting; adjusting entries; Chapters 1 and 2

• LO2–4, LO2–8

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 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 performance than net operating cash flow?

3. Explain the purpose of adjusting entries as they relate to the difference between cash and accrual accounting.