You have recently been hired by Davis Company a small publi

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.\"
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.

Solution

Respected Sir,

I am writing to you in order to acquaint yourself with the fact that accounting on the basis of accruals is often considered over that on the basis of cash.

For example, you may have a high cash inflow, but also on the other hand, this might be of no value to your firm if you have high trade payables as well. This can arise particularly when you make majorly account purchases on credit instead of cash. This increases your liability. Hence, even with high cash inflows, you might also have high liabilities which will make repayment of loan difficult. Hence accounting on the basis of accruals concept is mandatory to be presented.

I hope I have addressed your concern.

Thank you.