UNIT 3: CASH FLOWS AND INCOME MEASUREMENT

3.1. INTRODUCTION

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.

Check your progress-1

1. Define the term cash flows.
_____________________________________________________________________

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3.2. ACCRUAL BASIS OF ACCOUNTING.

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.

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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]

3.3. CASH BASIS OF ACCOUNTING.

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.

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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.

Check your progress – 2

Distinguish between the cash basis of accounting and the accrual basis of accounting.

Illustration:
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 Adjustments to Income

under restate to statement
Cash basis of Accrual basis Under accrual
accounting of accounting Basis of
accounting

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 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

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 = 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
a) the accrual basis of accounting.
b) 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:
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

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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…………… 273,600
Cost of merchandise available for sale……………….348,600……………...348,600
Less: Ending inventory……………………………….(72,100
inventory……………………………….(72,100)……………..(
)……………..(72,100
72,100))
Cost of merchandise sold………………………………....(276,500
sold………………………………....(276,500)…………….(
)…………….(276,500
276,500))
Gross profit on sales…………………………………...Br. 185,700……………Br. 185,700
Operating Expense (79,400+4100 – 9500 +3200 – 2800)………...98,400
………...98,400..
..(79,400+24,000)..103,400
..103,400
Income before income tax…………………………………..87,300…………………82,300
Income tax Expense………………………………………...39,285
Expense………………………………………...39,285…………………
…………………37,035
37,035
Net income…………………………………………… Br.
Br. 48,015………………Br.
48,015………………Br.45,265
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
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
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
expenses…………………………..XX
Operating expenses under accrual basis……………………………….XX
basis……………………………….XX
Rent receipts…………………………………………………...XX

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Add: Ending rent receivable…………………………………...XX
Beginning unearned rent…………………………………XX
Less: Ending unearned rent…………………………………….XX
Beginning rent receivable……………………………… XX
Rent revenue……………………………………………………XX
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.

3.5 ANSWERS TO CHECK YOUR PROGRESS.

1. Cash flows refer to the inflows (receipts) or out flows (payments) of cash.
2. Under the cash basis of accounting, revenue is recorded when cash collections from
customers are received, expenses are recorded when they are paid in cash. Under the
accrual basis of accounting, revenue is recorded when it is realized (generally at the
time of sale), and expenses are recorded when incurred, without regard to the time of
receipt or payment of cash.

3.6 MODEL EXAMINATION QUESTIONS

I. Exercises
1. Cash paid by Life Corporation for operating expenses during the month of October, year
10, totaled Br. 16,480. Short –term prepayments and accrued liabilities were as follows:

October1,year 10 December 31,yeat 10

Short – term prepayments………………………..Br. 1,240……………………..Br. 1,690
Accrued liabilities……………………………………2,570…………………………1,820

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Required:
Required: Compute LIFE Corporation’s operating expenses for the month of October,
Year 10, under the accrual basis of accounting.
2. The following summarized data were taken from the records of Peppe company at
December 31, 1992, end of the accounting year.

a) Sales: 1992 cash sales were Br. 150,000, and 1992 credit sales were Br. 120,000.
b) Cash collections during 1992: Br. 40,000 on 1991 credit sales, Br. 80,000
c) Expenses: 1992 cash expenses were Br 180,000, and 1992 credit expenses were Br.
70,000
d) Cash payments during 1992: Br. 20,000 for 1991 credit expenses, Br. 40,000 for 1992
credit expenses, and Br. 9000 for 1993 expenses (paid in advance)

Required (1). Complete the following statements for 1992 as a basis for evaluating the
difference between cash and accrual accounting

Cash basis Accrual basis

Sales revenue………………………………….Br________ Br. _______
Expenses…………………………………………________ _______
Net income………………………………………_________ ________

(2) Which basis is in conformity with GAAP? Explain the reasons for your answer.

3. SOYN Company owns a small building with offices that it rents under contracts calling for
payments either monthly or yearly in advance. However, some tenants are delinquent in their
rent payments. During year, SOYN received Br. 20,000 form tenants. SOYN’S ledger
account balances for year 2 included the following.

Jan 1,year 2 DEC. 31, year 2

Rent Receivable…………………………….Br. 2,400………………Br. 3,100
Unearned Rent…………………………………8,000……………………6,000

Required:
Required: Complete SOYN Company’s rent revenue for year 2 under the accrual basis of
accounting

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4 Unearned revenue was Br.1,300 at the end of November, and Br.900 at the end of
December. Service revenue. Was Br. 5,100 for the month of December. How much cash
was received for service provided during December?
5 The income statement for Joy company included the following expenses for 1990
Rent Expense………………….Br. 5,200
Interest Expense………………….. 7,800
Salaries Expense………………….83,700

Listed below are the related balance sheet account balances at year end for last year (1989)
and this year (1990).
Last Year.
Year. This Year.
Prepaid rent……………………___ ………………..Br. 900
Interest payable……………..Br. 1,200 __
Salaries Payable………………...5,000………………….9,600

Required:
1. Compute the cash paid for rent during 1990
2. Compute the cash paid for interest during 1990.
3. Compute the cash paid for salaries during 1990.

3.7. GLOSSARY

1. Accrual basis of Accounting – the approach to preparing financial statements based on

recognizing revenue when they are earned and matching expenses to those revenues;
the basis for generally accepted accounting principles.
2. Cash basis of Accounting – the approach to preparing financial statements based on
recognizing revenues when the cash is received and reporting expenses when the cash
is paid; not generally accepted.
3. Cash flows – the amount of cash paid out or received during an accounting period and
the resulting availability of cash

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