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54Chapter 2 The Cash Basis of AccountingControlsUsing the accounting equation as a framework for designing an accounting system provides the control that, after recording transactions, total assets must equal total liabilitiesplus total stockholders’ equity. If at the end of the period the equality does not hold, thenan error has occurred in either recording or summarizing transactions. For example, if a 10,000 purchase of equipment for cash is incorrectly recorded as an increase in bothequipment and cash, the total assets will exceed the total liabilities and stockholders’ equity by 20,000 at the end of theWhen 3,000 of cash was receivedperiod. Likewise, if equipment was increased by 10,000, butfor fees earned, it was erroneouslycash was not decreased by 10,000, the total assets will exceedrecorded as an increase in cashtotal liabilities and stockholders’ equity by 10,000 at the endof 300 and an increase in reof the period. In both cases, the inequality of the equation willtained earnings (fees earned) ofindicate that an error has occurred in the recording process. 3,000. Will the accountingBefore the financial statements are prepared, errors can beequation balance?discovered and corrected. However, the equality of the equationat the end of the period doesn’t necessarily mean that no errorsNo. Total assets will be less than total liabilities plus stockholders’have occurred. For example, assume that a business purchasedequity by 2,700. 10,000 of equipment on credit and recorded the transaction asan increase in equipment of 10,000. However, instead of increasing the liabilities by 10,000, the transaction was recorded as a 10,000 decrease in cash. In this case, the accounting equation still balances, even though cash and liabilities are understated by 10,000. For this reason, accounting systems are designed with additional controls forrecording and summarizing transactions. We will discuss these controls in later chapters.Cash and Accrual Bases of Accounting2Describe the cashand accrual basesof accounting.Accounting systems are based upon either the cash basis or the accrual basis of accounting. The accrual basis is used by large businesses and is required of publicly held corporations, such as Amazon.com and Wm. J. Wrigley Jr. Company. The cash basis ofaccounting is often used by individuals and small businesses.1 For example, you probably use a cash basis because your checkbook is your primary accounting record. You keeptrack of your deposits (cash receipts) and checks (cash payments). Periodically, the banksends you a statement that you use to verify the accuracy of your record keeping.Both the cash and accrual bases of accounting use the business entity, cost, going concern, objectivity, unit of measure, adequate disclosure, and accounting period conceptsdiscussed in Chapter 1. As we will discuss in the following paragraphs, the primary difference between the cash and accrual bases of accounting involves the matching concept.Using the Cash Basis of AccountingUnder the cash basis of accounting, a business records only transactions involvingincreases or decreases of its cash. To illustrate, assume that a real estate agency sells a 300,000 piece of property on December 28, 2003. In selling the property, the agency earnsa commission of 8 percent of the selling price. However, the agency does not receive the 24,000 commission check until January 3, 2004. Under the cash basis, the real estateagency will not record the commission (revenue) until January 3, 2004.Under the cash basis, expenses are recorded only when cash is paid. For example, aDecember cellular phone bill that is paid in January would be recorded as a January ex-1 Some business may use a modified-cash or tax basis of accounting. These bases of accounting are covered in advanced accounting texts.

55Chapter 2 The Cash Basis of AccountingStrategy in BusinessGot the Flu? Why Not Chew Some Gum?acing a slumping market forsugared chewing gum, such asJuicy Fruit and Doublemint,Wm. J. Wrigley Jr. Company isreinventing itself with a strategy toexpand its product lines and introduce new chewing gum applications. Wrigley’s new productsinclude sugarless breath mints andmore powerful flavored mint chewing gum, like Extra Polar Ice. In ad-Fdition, Wrigley is experimentingwith health-care applications ofchewing gum. Wrigley’s HealthCare Division has already developedSurpass, an antacid chewing gumto compete with Rolaids and Mylanta. In addition, Wrigley is experimenting with a cold-relief chewinggum and a gum that would providedental benefits, such as whiteningteeth and reducing plaque. Giventhat the U.S. population is aging,the company figures that peoplemight prefer chewing gum to taking pills for sore throats, colds, orthe flu. The effects of these newstrategic initiatives will ultimatelybe reflected in Wrigley’s financialstatements.Source: Adapted from “A Young Heir Has New Plans atOld Company,” by David Barboza, The New York Times,August 28, 2001.pense, not a December expense. Thus, under the cash basis, the matching concept doesnot determine when expenses are recorded. That is, expenses are recorded when paid incash, not necessarily in the period when the revenue is earned.On June 30, a lawyer billed aclient for 4,000 for legalservices provided during June.The client paid 1,500 in Julyand 2,500 in August. Underthe cash basis, when are thefees earned recorded?June, 0; July, 1,500; August, 2,500Using the Accrual Basisof AccountingUnder the accrual basis of accounting, revenue is recordedas it is earned, regardless of when cash is received. To illustrate,using the preceding example, the real estate agency would recordthe commissions (revenue) of 24,000 as earned on December 28,2003, even though the check (cash) is not received until January3, 2004. Once revenue has been earned and recorded, any expensesthat have been incurred in generating the revenue are recorded andthus matched against that revenue. For example, a December cellular phone bill would berecorded in December as an increase in expenses and liabilities, even though it is not paiduntil January. In this way, the December phone expense is matched against the revenueit helped generate in December.Summary of Differences between theCash and Accrual Bases of AccountingExhibit 1 summarizes the basic differences of how revenue and expenses are recorded under the cash and accrual bases of accounting.Cash BasisAccrual BasisRevenue is recordedWhen cash is receivedWhen revenue is earnedExpense is recordedWhen cash is paidWhen expense is incurred ingenerating revenueExhibit 1Cash versus AccrualAccounting

56Chapter 2 The Cash Basis of AccountingEthics in ActionChannel Stuffingo boost earnings prior to theend of a reporting period,managers will sometimes engage in the questionable practice of“channel stuffing.” Channel stuffingTenhances revenue (accrual-basis)by persuading a distributor to takeadditional products. The practicebackfired for Lucent Technologies,which had to take back 452 mil-lion of equipment from distributors,causing a reversal of previouslyrecognized revenue.In the remainder of this chapter, we illustrate recording transactions and preparing financial statements using the cash basis of accounting. We will illustrate the accrual basis of accounting in Chapter 3. Because the cash basis is simpler, it will allow us to betterfocus on how the accounting equation is used as the framework for accounting systems.In addition, a thorough understanding of the cash basis will enhance your understandingof the accrual basis. In turn, this understanding will facilitate your ability to analyze andinterpret the financial statements of publicly held corporations prepared under the accrualbasis.Using the Cash Basis for a Corporation’sFirst Period of Operations3Use the cash basisof accounting toanalyze, record, andsummarize transactions fora corporation’s first periodof operations.Using the accounting equation as our basic framework, we will illustrate the recording oftransactions under the cash basis of accounting. We will assume that on September 1,2003, Lee Landry, M.D., organizes a professional corporation to practice general medicine.The business is to be known as Family Health Care, P.C. We describe each transaction orgroup of similar transactions during September, the first month of operations. We thendescribe how the accounting equation can be used to analyze the effects of the transactions on the financial condition of the business. We will begin with Dr. Landry’s investment to establish the business.Transaction a Dr. Landry deposits 6,000 in a bank account in the name of FamilyHealth Care, P.C., in return for shares of stock in the corporation. We will refer to stockissued to owners (stockholders) such as Lee Landry as capital stock. The effect of thistransaction is to increase the asset (cash), on the left side of the equation, by 6,000.Increases are recorded as positive numbers, while decreases are recorded as negativenumbers. Thus, the 6,000 deposit is recorded as a positive addition to Cash. To balance the equation, the stockholders’ equity (capital stock) on the right side of the equation is increased by the same amount. This 6,000 is recorded as a positive addition toCapital Stock. The effect of this transaction on Family Health Care’s accounting equation is shown below.

57Chapter 2 The Cash Basis of AccountingAssets Stockholders’ EquityCasha. 6,000Capital Stock6,000Investment by Dr. LandryNote that the equation relates only to the business, Family Health Care, P.C. Lee Landry’spersonal assets (such as a home or a personal bank account) and personal liabilities areexcluded from the equation. The business is treated as a separate entity, with cash of 6,000 and stockholders’ equity of 6,000.Transaction b Family Health Care’s next transaction is to borrow 10,000 from FirstNational Bank to finance its operations. To borrow the 10,000, Lee Landry signed anote payable in the name of Family Health Care. The note payable is a liability or aclaim on assets that Family Health Care must satisfy (pay) in the future. In addition, thenote payable requires the payment of interest of 100 per month until the note is duein full on September 30, 2009. At the end of September, we will record the payment of 100 of interest.The items in the equation prior to the borrowing transaction and the effect of the borrowing transaction are shown next. The new amounts or balances of the items are alsoshown.Assets Liabilities Stockholders’ EquityNotesCash Payablea.6,000b.10,00010,000Bal. 16,00010,000Capital Stock6,000Loan from bank6,000Observe how this transaction changed the mix of assets and liabilities but did not changeFamily Health Care’s stockholders’ equity. That is, assets minus liabilities still equals stockholders’ equity of 6,000.Transaction c Next, Family Health Care buys land for 12,000 cash. The land is located near a new suburban hospital that is under construction. Lee Landry plans to rentoffice space and equipment for several months. When the hospital is completed, Family Health Care will build on the land.The purchase of the land changes the makeup of the assets, but it does not change thetotal assets. The effect of this transaction on the accounting equation is shown below.Assets Liabilities Stockholders’ EquityNotesCash Land PayableBal.16,00010,000c. 12,00012,000Bal.4,00012,00010,000Capital Stock6,000Purchase of land6,000Transactions (b) and (c) have not improved the stockholders’ equity of Family Health Care.They have simply changed the mix of assets and increased the liability, notes payable. However, the objective of businesses is to improve stockholders’ equity through operations.

58Chapter 2 The Cash Basis of AccountingEthics in ActionPhony Shares of Stocknethical practices can occurin promoting the issuanceof stock to stockholders. Itwould be considered fraudulent toUhide known risks from potentialstockholders and to use stock proceeds for purposes other than indicated or for selling counterfeitshares. For example, two peoplepled guilty for fraudulently selling 15 million of phony shares ofMindArrow Systems, Inc., stock.How does a business improve the stockholders’ equity? By earning revenues in excessof expenses. Revenues increase stockholders’ equity through the business operations, whileexpenses decrease stockholders’ equity. When revenues for a period exceed the expensesused to earn the revenues, the financial condition of the business will have improved. Thisimprovement in financial condition results in an increase in the stockholders’ equity ofthe business. Likewise, if the expenses exceed the revenues for a period of time, the stockholders’ equity of the business will decrease. For this reason, transactions involving revenues and expenses are recorded as part of stockholders’ equity in the accounting equation.In the following paragraphs, we illustrate the recording of revenue and expense transactions for Family Health Care.Transaction d During the first month of operations, Family Health Care earns patientfees of 5,500, receiving the amount in cash. These transactions increase cash and thestockholders’ equity by 5,500, as shown below.Assets Liabilities Stockholders’ EquityNotesCash Land PayableBal. 4,00012,00010,000d.5,500Bal. 9,50012,00010,000CapitalRetained Stock Earnings6,0005,500Fees earned6,0005,500Unlike transactions (b) and (c), the stockholders’ equity of Family Health Care has increased by 5,500 as a result of this transaction. You should note that the increase instockholders’ equity from revenue is listed in the equation under “Retained Earnings.”Retained earnings is the stockholders’ equity created by the business operations (revenuesless expenses). Transactions affecting earnings are kept separate from transactions relatedto stockholders’ investments (capital stock). This is useful in preparing reports to ownersand creditors and in satisfying some states’ legal requirements that we will discuss laterin the text.Transaction e For Family Health Care, the expenses paid during the month were asfollows: wages, 1,125; rent, 950; utilities, 450; interest, 100; miscellaneous, 275.Miscellaneous expenses include small amounts paid for such items as postage due andnewspaper and magazine purchases. This group of expense transactions reduces cashand stockholders’ equity, as shown below.

59Chapter 2 The Cash Basis of Accounting Liabilities Stockholders’ EquityAssetsNotesCash Land PayableBal.9,50012,00010,000e. 2,900Bal.6,60012,00010,000CapitalRetained Stock Earnings6,0005,500 1,125 950 450 100 2756,0002,600Wages expenseRent expenseUtilities expenseInterest expenseMisc. exp.Transaction f At the end of the month, Family Health Care pays 1,500 to stockholders(Dr. Lee Landry) as dividends. Dividends are distributions of business earnings to stockholders. Dividend payments reduce cash and stockholders’ equity. The effect of this transaction is shown as follows: Liabilities Stockholders’ EquityAssetsNotesCash Land PayableBal.6,60012,00010,000f. 1,500Bal.5,10012,00010,000CapitalRetained Stock Earnings6,0002,600 1,500 Dividends6,0001,100You should be careful not to confuse dividends with expenses. Dividends do not represent assets consumed or services used in the process of earning revenues. The decrease instockholders’ equity from dividends is listed in the equation under “Retained Earnings.”This is because dividends are considered a distribution of earnings to the owners.The transactions of Family Health Care are summarized as follows in Exhibit 2. Thetransactions are identified by letter, and the balance of each item is shown after eachtransaction.Family Health CareSummary ofTransactions forSeptember Liabilities Stockholders’ EquityAssetsExhibit 2NotesCash Land Payablea.6,000b.10,00010,000Bal.16,00010,000c. 2,00010,000e. 2,900Bal.f.Bal.6,600 1,5005,10012,00010,00012,00010,000CapitalRetained Stock Earnings6,000InvestmentLoan from bank6,000Purchase of land6,0005,500 Fees earned6,0005,500 1,125 Wages expense 950 Rent expense 450 Utilities expense 100 Interest expense 275 Miscellaneous exp.6,0002,600 1,500 Dividends6,0001,100

60Chapter 2 The Cash Basis of AccountingIn reviewing the preceding illustration, you should note the following, which apply to alltypes of businesses:1.The effect of every transaction is an increase or a decrease in one or more of theaccounting equation elements.2.The two sides of the accounting equation are always equal.3.The stockholders’ equity is increased by amounts invested byA physician refunded 300 tostockholders (capital stock). In addition, stockholders’ equitya patient for an incorrect bill.(retained earnings) is increased by revenues and decreased byHow would you record thisexpenses. Finally, stockholders’ equity (retained earnings) istransaction?decreased by dividends distributed to stockholders. The effectDecrease assets (cash) 300, and decreaseof these four types of transactions on stockholders’ equity isretained earnings (fees earned) by 300.illustrated in Exhibit 3.Exhibit 3Effects of Transactionson Stockholders’EquityS TO C K H O L D E R S’ E Q U IT YFinancial Statements for a Corporation’sFirst Period of Operations4Use the cash basisof accounting toprepare financialstatements for the firstperiod of operations.Exhibit 4Family Health CareFinancial Statementsfor SeptemberIn Exhibit 2, the September transactions for Family Health Care are listed in the orderthat they occurred. This exhibit, however, is not very user-friendly in that it does notgroup and summarize like transactions together. As we described and illustrated in Chapter 1, the accounting reports that provide this summarized information are the financialstatements.The September financial statements for Family Health Care are illustrated in Exhibit 4.Family Health Care, P.C.Retained Earnings StatementFor the Month Ended September 30, 2003Net income for SeptemberLess dividendsRetained earnings, September 30, 2003 2,6001,500 1,100

61Chapter 2 The Cash Basis of AccountingExhibit 4Family Health Care, P.C.Income StatementConcludedFor the Month Ended September 30, 2003Fees earnedOperating expenses:Wages expenseRent expenseUtilities expenseInterest expenseMiscellaneous expensesTotal operating expensesNet income 5,500 1,1259504501002752,900 2,600Family Health Care, P.C.Balance SheetSeptember 30, 2003AssetsCashLandTotal assets 5,10012,000 17,100LiabilitiesNotes payable 10,000Stockholders’ EquityCapital stockRetained earningsTotal liabilities and stockholders’ equity 6,0001,1007,100 17,100Family Health Care, P.C.Statement of Cash FlowsFor the Month Ended September 30, 2003Cash flows from operating activities:Cash received from customersDeduct cash payments for expensesNet cash flow from operating activitiesCash flows from investing activities:Cash payments for acquisition of landCash flows from financing activities:Cash received from sale of cap. stockCash received from notes payableDeduct cash dividendsNet cash flow from financing activitiesNet increase in cashSeptember 1, 2003 cash balanceSeptember 30, 2003 cash balance 5,5002,900 2,600(12,000) 6,00010,000 16,0001,50014,500 5,1000 5,100

62Chapter 2 The Cash Basis of AccountingThe data for the statements were taken from the transactions summary shown in Exhibit2. You should note that each financial statement is identified by the name of the business, the title of the statement, and the date or period of time.Income StatementAs shown in Exhibit 4, the income statement for Family Health Care reports fees earnedof 5,500, total operating expenses of 2,900, and net income of 2,600. The 5,500 offees earned was taken from the Retained Earnings column of Exhibit 2. Likewise, the expenses were summarized from the Retained Earnings column of Exhibit 2 and reportedunder the heading “Operating expenses.” The expenses were listed in order of size, beginning with the largest expense. Miscellaneous expense is usually shown as the last item,regardless of the amount. The total operating expenses were then subtracted from the feesearned to arrive at the net income of 2,600. The effect of this net income will be to increase retained earnings and stockholders’ equity.Retained Earnings StatementSin

The Cash Basis of Accounting THE LAW OF E.F. HUTTON "When the real leader speaks, people listen." —The 21 Irrefutable Laws of Leadership Dr. John C. Maxwell Learning Goals 1 Describe the basic elements of a financial accounting system. 2 Describe the cash and accrual bases of accounting. 3Use the cash basis of accounting toanalyze, record .