Cash Flows and Income Measurement

Investors and creditors are interested in cash – flow information when evaluating investment opportunities.  Accrual information helps investors estimate future net cash flows and the risks associated with these flows.  It does so through the accruals included in the income statement and the balance sheet (such as the bad debt allowance), and in general through the matching process that leads to the accrual and the deferral of expenses and revenues.

Accountants assume that a business enterprise has continuous existence.  Therefore, they record the prospect of future cash inflows as increase in assets and as revenue whenever they have reliable evidence of the amount of the future cash receipt.  Cash in flows often occur before an enterprise has performed its part of a contract.  In this case, an increase in asset (cash) is recorded, but a liability is recognized instead of revenue.  The liability indicates an obligation on the part of the enterprise to perform in accordance with the contact.  When performance is completed the revenue is recognized i.e. a debit to liability and a credit to revenue is recorded.  Thus, cash inflows are closely related to revenue realization; however, the assumptions underlying the timing of revenue realization do not always permit cash inflows and revenue to be recorded in the same accounting period.

Similarly, cash outflows are closely related to expense of a business enterprise; however, cash outflows and expenses may not be recorded in the same accounting period.  For example, enterprises frequently acquire for cash in one period assets that will be productive over several future periods; and assets that are productive only during the current period often are acquired in exchange for a promise to pay cash in a future period.

 

Accrual basis of accounting is a system of accounting that requires an event that alters the economic status of a firm as represented in its financial statements be recorded (recognized) in the period in which the event occurs rather than in the period when cash changes hands.

When accrual basis of accounting is used, revenues are reported in the income statement when they are earned and expenses are reported in the income statement when they are incurred, without regard to the timing of cash receipt or payment.  When we say revenues are earned it means the service is rendered or the items are sold, and when we say expenses are incurred, it means that employees are engaged or services are used or items are consumed.

Under the accrual basis of accounting, the accounting records are adjusted periodically to ensure that all assets and liabilities (and thus revenue and expenses) are correctly stated.  That is, the accrual basis of accounting is inline with the matching principle therefore net income under this basis is determined as realized revenue minces incurred expenses.

The general rule for determining the cash flows received from any revenue or paid for any expenses (except depreciation is to determine the potential cash payments or receipts and deduct the amount not paid or received.  The application of the general rule varies with the type of asset or liability account as shown below:

Type of account          Potential payment of Receipt             not paid or received     Result. Prepaid expense    Ending balance + Expense for the period – Beginning balance =  cash payment                                                                                                                                        for expenses   Unearned                                                                                                                       cash Receipts  Revenue                Ending balance + Revenue for the period – Beginning balance = from revenues   Accrued                                                                                                                         Cash payment Liability                 Beginning balance + Expense for the period – Ending balance = for expenses   Accrued                                                                                                                        Cash receipts Receivable             Beginning balance + revenue for the period – ending balance = from revenues.

For instance, assume that on May 31 a company had a balance of Br 480 in prepaid Insurance and that on June 30 the balance was Br. 670.  If the insurance expense during June was Br.120, the amount of cash expended (paid) on insurance during June can be computed as follows:

            Prepaid Insurance at June 30……………………………………..Br. 670

            Insurance Expense during June…………………………………..      120

            Potential cash payments for insurance…………………………....Br.790

            Less: prepaid insurance at May 31………………………………..     480

            Cash payments for insurance during June…………………………    310

The beginning balance is deducted because it was paid in a prior accounting period.  Note that the cash payments equal the expense plus the increase in the balance of prepaid insurance account [Br. 120 +(Br. 670 – Br 480) = Br. 310]

 

It is an accounting system based on the timing of cash payments and receipts.  Under the cash basis of accounting revenue is recorded only when cash is received and expenses are recorded only when cash is paid.  Under the cash basis of accounting, net income is determined as collection of revenue minus payment of expenses.  Financial statements prepared under the cash basis of accounting do not represent the financial position or operating results of an enterprise in conformity with GAAP since it is not compatible with the matching principle.  As a result, A strict cash basis of accounting seldom is found in practice, but a modified cash basis

 (a mixed cash – accrual basis)

Under the modified cash basis of accounting, which is mostly used for income tax purpose, the entire cost of property having an economic life of more than one year may not be deduced in the year of acquisition.  It must be treated as an asset to be depreciated over its economic life.  Expenses such as rent or advertising paid in advance also are regarded as assets and are deductible only in the year or years to which they apply.  Expenses paid after the year in which incurred are deductible only in the year paid.  Revenue is reported in the year received. 

However, in any business enterprise on which the purchase, production, or sale of merchandise is a significant factor, these transactions must be reported on the accrual basis (in the period earned or incurred).  Thus for a merchandising enterprise the revenue from sale, the cost of goods sold, and the gross profit on sales will be the same under the accrual basis of accounting as under the modified cash basis of accounting.

 

 

Illustration:  The difference between the cash basis and accrual basis of accounting is illustrated below for SKY Company, which maintains accounting records on a cash basis.

During year 10, SKY Co. collected Br. 150,000 from its clients and paid Br. 80,000 for operating expenses, resulting in a cash basis net income of Br. 70,000.  SKY company’s fees receivables, accrued liabilities, and short –term prepayments on January 1 and on December 31,year 10, were as follows:

                                                 January 1,year 10                    December 31,year 10.

Fees receivable  …………………Br. 18,200                       Br. 37,000

Accrued liabilities………………...6,200                                     4,000

Short – term prepayments……..3,500                                       2,500

A working paper showing the necessary adjustments to restate SKY Company’s income statement from the cash basis of accounting to accrual basis of accounting is illustrated below:

                                                                                  SKY Company

                               Working paper to restate Income Statement from cash basis to Accrual basis.

                                                        For the Year ended December 31, year 10.

	Income statement  under Cash basis of accounting	Adjustments to  restate to Accrual basis  of accounting		Income statement Under accrual Basis of accounting
		Added	Deducted
Revenue from fees received in cash	Br. 550,000
Add: Fee Receivables, Dec. 31,year 10		Br.37,000
Less: Fees receivable, Jan.1, year 10			Br. 18,200	Br. 168,800
Operating expenses paid in cash	Br. 80,000
Add: Accrued liabilities, Dec.31,year 10		4,000
Short – term prepayments, Jan1,year10		3,500
Less: Accrued liabilities, Jan 1, year 10			6,200
Short – term prepayments, Dec 31, year 10	_______________		2,500	78,800
Net income under cash basis of accounting	Br. 70,000
Net income under accrual basis of accounting			Br. 90,000

 

The adjustments to restate operating expenses and fees revenue from the cash basis of accounting to accrual basis of accounting are explained below:

1. The amount of accrued liabilities on December 31, year 10, representing expenses incurred in year 10 that will be paid in year 11, and the amount of short – term prepayments on January 1, year 10, represents services paid for in year 9 that were consumed in year 10.  Therefore, both amounts are added to the amount of cash paid to restate the operating expenses for year 10 to the accrual basis of accounting.
2. The amount of accrued liabilities on January 1, year 10, represents expenses of year 9 paid for in year 10, and the amount of short – term prepayments on December 31, year 10, represents cash outlays in year 10 for services that will be consumed in year 11.  Therefore, both amounts are deducted from the amount of cash paid to restate the operating expenses for year 10 to the accrual basis of accounting.
3. Because the revenue from fees under the cash basis does not include the fees receivable on December 31, which were realized in year 10, this amount is added to the cash collected in the restatement of revenue from fees to the accrual basis of accounting.  Because fees receivable on January 1 were realized in year 9 and collected in year 10, this amount is subtracted from cash collections in the restatement of revenue from fees to the accrual basis of accounting.  That is :  Fees received (collected) + Ending Fees receivable = Beginning receivable

                 = 150,000 + 37,000 – 18,200

                 =Br.168, 800 = Fees revenue under accrual basis of accounting.

 

General Illustration.

A Summary of operating results for FENOTE Company for year 2 is presented below:

            Cash collected from customers………………………………Br. 466,000

            Cash paid for merchandise suppliers……………………………..268,200

            Cash paid for operating expenses……………………………….... 79,400

The following data were taken form comparative balance sheets prepared on the accrual basis of accounting.

                                                                    December 31, year1           December 31,year 2

Accounts receivable…………………………..Br. 52,400………………Br. 48,600

Inventories………………………………………...75,000………………..72,100

Short – term prepayments………………………… 4,100………………9,500

Accounts payable (merchandise suppliers)………32,000……………37,400

Accumulated deprecation (there were no

Disposal of plant assets during year 2)…………   50,000…………………………..74,000

 

Instructions:

Prepare income statement for FENOTE company for year 2 under

1. the accrual basis of accounting.
2. The modified cash basis of accounting where by operating expenses (other than depreciation) are computed on the cash basis.  FENOTE Company’s income is taxed at 45%

Solution: (a)                FENOTE Company

                                    Income statement

                        For the year ended Dec. 31, year 2.

          (a)                                                (b)

                                                                 Accrual basis                         Modified cash basis

                                                                  of Accounting                           of accounting

Sales (46,600 + 48,600 – 52,400)………..Br. 462,200……………..Br. 462,200

Cost of merchandise sold:

Beginning Inventory………………………………..Br. 75,000………………75,000

Add: Purchases (268,000 + 31,400 – 32,000)………   273,600……………  273,600

Cost of merchandise available for sale……………….348,600……………...348,600

Less: Ending inventory……………………………….(72,100)……………..(72,100)

Cost of merchandise sold………………………………....(276,500)…………….(276,500)

Gross profit on sales…………………………………...Br. 185,700……………Br. 185,700

Operating Expense (79,400+4100 – 9500 +3200 – 2800)………...98,400..(79,400+24,000)..103,400

Income before income tax…………………………………..87,300…………………82,300

Income tax Expense………………………………………...39,285…………………37,035

Net income……………………………………………   Br. 48,015………………Br.45,265

 N.B.

* Cash receipt form customers……………………………………XX

 Plus: Cash discount…………………………………..XX

            Sales returns and allowance…………………..XX

            Accounts written – off………………………..XX             

            Ending Accounts receivable………………… XX……XX

Less: Beginning Accounts receivable…………………………(XX)        Under accrual &modified

Gross sales……………………………………………………..XX          cash basis

* Cash paid for merchandise suppliers……………………….. XX

Add: Ending Accounts payable………………………………..XX

Less: Beginning Accounts Payable…………………………   (XX)

Purchase under accrual and modified cash basis………………………XX

*Cash paid for operating expenses…………………………….............XX

Add:  Beginning prepaid expenses……………………………XX

            Ending accrued expenses……………………………...XX

Less:  Ending prepaid expenses……………………………….XX

            Beginning accrued expenses…………………………..XX

Operating expenses under accrual basis……………………………….XX

Rent receipts…………………………………………………...XX

Add: Ending rent receivable…………………………………...XX

         Beginning unearned rent…………………………………XX

Less: Ending unearned rent…………………………………….XX

         Beginning rent receivable………………………………   XX

Rent revenue……………………………………………………XX

 

3.4 SUMMARY

Information concerning cash flows during an accounting period is valuable in judging the ability of the business enterprise to pay its debt, to pay regular dividends, to finance replacements of productive assets, and to expand its scope of operations.  However, the increase or decrease in cash during a period is not useful in evaluating an enterprise’s operating performance, because cash receipts and payments are not representative of the economic activities carried on in specific period.