ACCOUNTING FUNDAMENTALS FOR MANAGERS University of Management and Technology 1901 North Fort Myer Drive Arlington, VA 22209 Voice: (703) 516-0035 Fax: (703) 516-0985 Website: www.umtweb.edu

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The Cash Basis of Accounting Chapter 2 The Cash Basis of Accounting

After studying this chapter, you should be able to: Learning Objectives Describe the basic elements of a financial accounting information system. Describe the cash and accrual bases of accounting. Use the cash basis of accounting to analyze, record, and summarize transactions for a corporation’s first period of operations. Use the cash basis of accounting to prepare financial statements for the first period of operations. After studying this chapter, you should be able to: Continued

Learning Objectives Use the cash basis of accounting for recording transactions and preparing financial statements for a second period of operations. Describe the advantages and disadvantages of the cash basis of accounting. Describe and illustrate how vertical analysis can be used to analyze and evaluate a company’s performance.

Learning Objective 1 Describe the basic elements of a financial accounting information system.

Stock-holders’ Equity Balance Sheet Assets = Liabilities Stock-holders’ Equity + The Accounting Equation The rights of creditors The rights of the stockholders

2 Describe the cash and accrual bases of accounting. Learning Objective 2 Describe the cash and accrual bases of accounting.

Under the cash basis of accounting, a business records only transactions involving increases or decreases in cash.

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

Learning Objective 3 Use the cash basis of accounting to analyze, record, and summarize transactions for a corporation’s first period of operations.

On September 1, 2003, Dr. Lee Landry organized a professional corporation to practice general medicine.

a. Dr. Landry deposits $6,000 in a bank account in the name of Family Health Care, P.C. in return for shares of stock in the corporation. Assets = Stockholders’ Equity Cash 6,000 Capital Stock 6,000 Investment by Dr. Landry a.

b. Family Health Care borrowed $10,000 from First National Bank. Stockholders’ Equity Assets = Liabilities + Cash 6,000 Notes Payable + Capital Stock 6,000 = a. b. 10,000 10,000 Bal. 16,000 10,000 6,000

c. Family Health Care buys land for $12,000 cash. Stockholders’ Equity Assets = Liabilities + Cash + Land Notes Payable + Capital Stock = Bal. 16,000 10,000 6,000 c. –12,000 12,000 Bal. 4,000 12,000 10,000 6,000

d. During the first month of operations, Family Health Care earns patient fees of $5,500, receiving the amount in cash. Stockholders’ Equity Assets = Liabilities + Cash + Land Notes Payable + Capital Stock Retained Earnings = Bal. 4,000 12,000 10,000 6,000 d. 5,500 Revenue  5,500 Bal. 9,500 12,000 10,000 6,000 5,500

e. The expenses for the month were as follows: wages, $1,125; rent, $950; utilities, $450; interest, $100; miscellaneous, $275. Stockholders’ Equity Assets = Liabilities + Cash + Land Notes Payable + Capital Stock Retained Earnings = Bal. 9,500 12,000 10,000 6,000 5,500 e. –2,900 Wages expense  –1,125 Rent expense  –950 Utilities expense  –450 Interest expense  –100 Misc. expense  –275 Bal. 6,600 12,000 10,000 6,000 2,600

f. Family Health Care pays $1,500 to stockholder (Dr f. Family Health Care pays $1,500 to stockholder (Dr. Landry) as dividends. Stockholders’ Equity Assets = Liabilities + Cash + Land Notes Payable + Capital Stock Retained Earnings = Bal. 6,600 12,000 10,000 6,000 2,600 f. –1,500 Dividends  –1,500 Bal. 5,100 12,000 10,000 6,000 1,100

The following apply to all 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 equation 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.

Stockholders’ Investments STOCKHOLDERS’ EQUITY Capital Stock Retained Earnings Stockholders’ Investments INCREASED BY Revenues Expenses Dividends INCREASED BY DECREASED BY

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

For the Month Ended September 30, 2003 Family Health Care, P.C. Income Statement For the Month Ended September 30, 2003 Fees earned $5,500 Operating expenses: Wages expense $1,125 Rent expense 950 Utilities expense 450 Interest expense 100 Miscellaneous expense 275 Total operating expenses 2,900 Net income $2,600 Revenue and expense amounts taken from the Retained Earnings column in Exhibit 2 of the textbook.

Retained Earnings Statement For the Month Ended September 30, 2003 Family Health Care, P.C. Retained Earnings Statement For the Month Ended September 30, 2003 Net income for September $2,600 Less dividends 1,500 Retained Earnings, September 30, 2003 $1,100 The net income is taken from the income statement (previous slide) and the amount of dividends from the Retained Earnings column in Exhibit 2 of the textbook.

Family Health Care, P.C. Balance Sheet September 30, 2003 All account balances were taken from the bottom row of Exhibit 2, except Retained Earnings. Assets Cash $ 5,100 Land 12,000 Total assets $17,100 Liabilities Notes payable $10,000 Stockholders’ Equity Capital stock $6,000 Retained earnings 1,100 7,100 Total liabilities and stockholders’ equity $17,100 Retained Earnings balance is taken from the retained earnings statement.

Total assets equal total liabilities plus stockholders’ equity. Family Health Care, P.C. Balance Sheet September 30, 2003 Assets Cash $ 5,100 Land 12,000 Total assets $17,100 Liabilities Notes payable $10,000 Stockholders’ Equity Capital stock $6,000 Retained earnings 1,100 7,100 Total liabilities and stockholders’ equity $17,100 Total assets equal total liabilities plus stockholders’ equity.

Statement of Cash Flows For the Month Ended September 30, 2003 Family Health Care, P.C. Statement of Cash Flows For the Month Ended September 30, 2003 Cash flows from operating activities: Cash received from customers $ 5,500 Deduct cash payments for expenses 2,900 Net 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 $ 6,000 Cash from notes payable 10,000 $16,000 Deduct cash dividends 1,500 Net cash flow from financing activities 14,500 Net increase in cash $ 5,100 September 1, 2003 cash balance 0 September 30, 2003 cash balance $ 5,100

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

a. Received fees of $6,400 in cash. Stockholders’ Equity Assets = Liabilities + Cash + Land Notes Payable + Capital Stock Retained Earnings = Bal. 5,100 12,000 10,000 6,000 1,100 a. 6,400 Revenue 6,400 Bal. 11,500 12,000 10,000 6,000 7,500

b. Paid expenses in cash as follows follows: wages, $1,370; rent, $950; utilities, $540; interest, $100; miscellaneous, $220. Stockholders’ Equity Assets = Liabilities + Cash + Land Notes Payable + Capital Stock Retained Earnings = Bal. 11,500 12,000 10,000 6,000 7,500 e. –3,180 Wages expense  –1,370 Rent expense  –950 Utilities expense  –540 Interest expense  –100 Misc. expense  –220 Bal. 8,320 12,000 10,000 6,000 4,320

c. Family Health Care pays $1,000 to stockholders (Dr c. Family Health Care pays $1,000 to stockholders (Dr. Landry) as dividends. Stockholders’ Equity Assets = Liabilities + Cash + Land Notes Payable + Capital Stock Retained Earnings = Bal. 8,320 12,000 10,000 6,000 4,320 c. –1,000 Dividends  –1,000 Bal. 7,320 12,000 10,000 6,000 3,320

For the Month Ended October 31, 2003 Family Health Care, P.C. Income Statement For the Month Ended October 31, 2003 To review the source of this amount, click the green button below. Fees earned $6,400 Operating expenses: Wages expense $1,370 Rent expense 950 Utilities expense 540 Interest expense 100 Miscellaneous expense 220 Total operating expenses 3,180 Net income $3,220 To review the source of expenses, click the orange button below. Revenue Expenses

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

The primary advantage of the cash basis of accounting is its simplicity.

The primary disadvantage of the cash basis is that revenues and expenses may not be properly matched on the income statement.

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

Statements can be compared by computing a percentage of each item within a statement to a total within the statement.

This type of analysis is called vertical analysis.

Vertical Analysis—Balance Sheet Assets: Cash and cash equivalents $ 307,785 Short-term investments 25,450 Accounts receivable 239,885 Inventories 278,981 Property, plant, and equipment 684,379 Other assets 229,168 TOTAL ASSETS $1,765,648 17.4% $307,785 $1,765,648

Vertical Analysis—Balance Sheet Assets: Cash and cash equivalents $ 307,785 Short-term investments 25,450 Accounts receivable 239,885 Inventories 278,981 Property, plant, and equipment 684,379 Other assets 229,168 TOTAL ASSETS $1,765,648 17.4% 1.4 $25,450 $1,765,648

Vertical Analysis—Balance Sheet Assets: Cash and cash equivalents $ 307,785 Short-term investments 25,450 Accounts receivable 239,885 Inventories 278,981 Property, plant, and equipment 684,379 Other assets 229,168 TOTAL ASSETS $1,765,648 17.4% 1.4 13.6 15.8 38.8 13.0 100.0%

Vertical Analysis—Balance Sheet Liabilities: Accounts payable $ 91,225 Dividends payable 42,741 Income and other taxes payable 68,467 Long-term liabilities 157,127 Other liabilities 129,891 Total liabilities $ 489,451 Stockholders’ equity: Total stockholders’ equity 1,276,197 TOTAL LIAB. & S.E. $1,765,648 5.2% $91,225 $1,765,648

Vertical Analysis—Balance Sheet Liabilities: Accounts payable $ 91,225 Dividends payable 42,741 Income and other taxes payable 68,467 Long-term liabilities 157,127 Other liabilities 129,891 Total liabilities $ 489,451 Stockholders’ equity: Total stockholders’ equity 1,276,197 TOTAL LIAB. & S.E. $1,765,648 5.2% 2.4 3.9 8.9 7.4 27.7% 72.3 100.0%

Vertical Analysis—Comparative Balance Sheets 2001 2000 Assets: Cash and cash equivalents Short-term investments Accounts receivable Inventories Property, plant, and equipment Other assets TOTAL ASSETS 17.4% 19.1% 1.4 13.6 15.8 38.8 13.0 100.0% 1.9 12.2 16.1 38.5 12.3 100.0%

Vertical Analysis—Comparative Balance Sheets 2001 2000 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. 5.2% 2.4 3.9 8.9 7.4 27.7% 72.3 100.0% 4.6% 2.5 3.9 9.8 7.3 28.1% 71.9 100.0%

Vertical Analysis—Income Statement Net sales $2,429,646 Cost of sales 997,054 Gross profit $1,432,592 Selling and administrative exp. 919,236 Operating income $ 513,356 Other income (expense) 14,010 Income before income taxes $ 527,366 Income taxes 164,380 Net income $ 362,986 100.0% 41.1 $997,054 $2,429,646

Vertical Analysis—Income Statement Net sales $2,429,646 Cost of sales 997,054 Gross profit $1,432,592 Selling and administrative exp. 919,236 Operating income $ 513,356 Other income (expense) 14,010 Income before income taxes $ 527,366 Income taxes 164,380 Net income $ 362,986 100.0% 58.9% $1,432,592 $2,429,646

Vertical Analysis—Income Statement Net sales $2,429,646 Cost of sales 997,054 Gross profit $1,432,592 Selling and administrative exp. 919,236 Operating income $ 513,356 Other income (expense) 14,010 Income before income taxes $ 527,366 Income taxes 164,380 Net income $ 362,986 100.0% 41.1 58.9% 37.8 21.1% 0.6 21.7% 6.8 14.9%

Vertical Analysis—Income Statement 2001 2000 Net sales Cost of sales Gross profit Selling and administrative exp. Operating income Other income (expense) Income before income taxes Income taxes Net income 100.0% 100.0% 41.1 42.1 58.9% 37.8 21.1% 0.6 21.7% 6.8 14.9% 57.9% 36.3 21.6% 0.7 22.3% 7.0 15.3%

a. Received fees of $6,400 in cash. Capital Stock Cash + 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

b. Paid expenses in cash as follows follows: wages, $1,370; rent, $950; utilities, $540; interest, $100; miscellaneous, $220. Capital Stock Stockholders’ Equity = Liabilities + Notes Payable + Retained Earnings Assets Cash + Land Bal. 11,500 12,000 10,000 6,000 7,500 e. –2,900 Wages expense  –1,370 Rent expense  –950 Utilities expense  –540 Interest expense  –100 Misc. expense  –220 Return to income statement Bal. 8,320 12,000 10,000 6,000 4,320