CASH FLOWS AND INCOME MEASUREMENT

Normally cash inflows and cash outflows are closely related to revenues and expenses
respectively. On the basis of realization, however, cash inflows and period’s revenue may not be
recorded in the same accounting period. Some cases for this timing difference include:

 cash received in advance before performance of contract by the seller. This is termed as
deferred or unearned revenue. This is first recorded as liability – future sacrifices of
economic benefits to provide service to other entities as a result of past transactions.
Later, periodical recognition of revenue is made for proportional amount of performance
completed. This reduces the associated liability previously recognized.

 performance by the seller is completed or partially completed in advance before the cash
collection. This is referred to as accrued revenue. This is the case that earning of revenue
occurred without cash collection. Thus, it is recorded as revenue as earned with the
related receivables.

In the same way, even if expenses and cash outflows are closely related, they may not be
accounted in the same accounting period due to reasons such as:

 Cash paid in advance before incurrence of expenses such as prepaid insurance, prepaid
rent, etc. This is termed as deferred expenses or short-term prepayments. Upon payment,
this is normally recorded as an asset and probable future economic benefits are
anticipated. Later when the costs are consumed or expired, they are recognized as
expenses.

 Consumption of resources or services before the cash outlay. This is the case of accrued
expense where it is recorded as an expense when incurred along with the related liability.

Income Measurement Approaches

Based upon the size, nature of companies and the intention as to how to treat revenues and
expenses, there are three different income measurement approaches:

1) The Accrual Basis of Accounting

2) The Cash Basis of Accounting

3) The Modified Cash Basis of Accounting.

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1. The Accrual Basis of Accounting

The accrual basis of accounting measures the entity’s accomplishments and resource sacrifices
during a period. It is mainly based on the matching principle and generally governed by the
Accounting Principles in that the accrual basis of accounting is based on the realization of
revenues and incurrence of expenses, and the matching of revenues realized and costs expired
(expenses). To put it in a nut shell, revenues are recognized when earned and expenses are
recognized when incurred, regardless to the timing of receipts and payments.

As far as the accrual basis of accounting follows the accounting principles advance collections
from customers will be treated as liabilities and the advance payments to other entities are
considered as assets. By the same reason the prepaid expenses are treated as assets than
expenses. For example; the owner of the house you rented would record an income event on the
day your rent comes due (you owe it to him). He records an expense event when the fee owed to
the rental agent comes due for your apartment that month (he owes it to the agent)

2. The Cash Basis of Accounting

The cash basis of accounting records revenue in accounting books when cash is collected. By the
same logic this approach records expenses when cash is paid. Thus in cash-basis accounting,
revenues and expenses are also called cash receipts and cash payments respectively. This fact
normally leads to the conclusion that cash-basis accounting does not recognize promises to pay
or expectations to receive money or service in the future, such as payables, receivables, and
prepaid expenses. For example, when you pay your rent, the owner of the house would record an
income event at the time he/she receives your payment. The owner of the house would
subsequently record an expense event when he/she pays the rental agent their fee for your
apartment. It is the accounting method used by most individuals, and by some businesses that
have limited payables or receivables or when the time lags between the initiation of the
transaction and the cash flow is very short. Thus, this model produces net operating cash flow,
which is the difference of cash receipts and cash disbursements during a reporting period from
transactions related to providing goods and services.

Net operating cash flow is very easy to understand and all information required is to measure it is
factual. Also, it certainly relates to a variable of critical interest to investors and creditors. What

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would be better in helping to predict future cash flows from selling products and services than
current cash flows from these activities? Remember that the company will be able to provide a
return to investors and creditors only if it can use the capital provided to generate a positive
operating cash flow. However, there is a major drawback to using the current period’s operating
cash flow to predict the future operating cash flow. Over the life of the company net operating
cash flow definitely is the variable of concern. However, over short periods of time operating
cash flows may not be indicative of the company’s long run cash generating ability (that is its
ability to generate positive net operating cash flow in the future.) In addition to this, Cash-basis
accounting fails to meet accounting principles requirements because it does not adhere to the
following two accounting principles:

 Revenue recognition principle - revenue should be recognized when it is realized

(e.g. a credit sale)

 Matching principle - revenue should be matched to the expense if possible (e.g.

sales to CGS)

3. The Modified Cash Basis of Accounting

The modified cash basis of accounting is a mixture of cash basis and accrual basis of accounting.
This method of accounting is appropriate for service rendering enterprises including law firms,
private hospitals, advertising agencies and public accountants. Under this method expenditures
having an economic life of more than one year are capitalized as assets and depreciated or
amortized over the future years. Prepayments of expenses are deferred and deducted only in the
year to which they apply, while expenses paid after the year of incurrence (accrued expenses) are
deducted only in the year paid. For a merchandising firm (where sale and purchase of
merchandise are significant) sales and cost of goods sold are determined under accrual basis.
Thus, for merchandising enterprise, the gross profit under modified cash basis is equal to gross
profit under accrual basis.

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 FINANCIAL ACCOUNTING I
Ch. 1 Cash Flows and Income Measurement

 Measurement of Income (Operating Results or Financial Performance / Progress)

Timing of Recognition
Accounting Basis Revenue Expense
Accrual Basis When Earned When Incurred
Cash Basis When Received When Paid
Modified Cash Basis Mixed Mixed

 Components of income for current period under cash and accrual basis of accounting
Revenues CBA ABA Remark
1 Earned and Collected in CYR  
2 Earned but not Collected in CYR  Accrued Revenues @ EYR
3 Previous Earnings Collected in CYR  Accrued Revenues @ BYR
4 Collected but Unearned in CYR  Unearned Revenues @ EYR
5 Previous Collections Earned in CYR  Unearned Revenues @ BYR
Expenses
1 Incurred and Paid in CYR  
2 Incurred but Unpaid in CYR  Accrued Expenses @ EYR
3 Incurred Previously but Paid in CYR  Accrued Expenses @ BYR
4 Previous Payments Incurred in CYR  Prepaid Expenses @ BYR
5 Paid but not Incurred in CYR  Prepaid Expenses @ EYR

 Restatement/Conversion Procedures
Acct Basis Indirect Method Direct Method
CBA Net Income xx = Cash Inflows xx - Cash Outflows xx
+ Adjustments + xx + Adjustments + xx + Adjustments + xx
ABA Net Income xx = Revenues Earned xx - Expenses Incurred xx
CBA ABA
For Both Direct + Accrued +Accrued Revenues @ EYR - Decrease in Accrued Revenues
& Indirect Revenues -Accrued Revenues @ BYR O +Increase in Accrued Revenues
R
For Both Direct + Unearned +Unearned Revenues @ BYR +Decrease in Unearned Revenues
& Indirect Revenues -Unearned Revenues @ EYR O -Increase in Unearned Revenues
R
For Direct but the + Accrued +Accrued Expenses @ EYR +Increase in Accrued Expenses
Reverse for Indirect Expenses -Accrued Expenses @ BYR O - Decrease in Accrued Expenses
R
For Direct but the + Prepaid +Prepaid Expenses @ BYR - Increase in Prepaid Expenses
Reverse for Indirect Expenses -Prepaid Expenses @ EYR O +Decrease in Prepaid Expenses
R

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 A cash or modified cash basis of accounting might be used in the following situations:
a. A company that is primarily interested in cash flows (for example, a group of physicians that
distribute cash basis earnings for salaries and bonuses)
b. A company that has a limited number of financial statement users (small, closely held
company with little or no debt)
c. A company that has operations that are relatively straightforward (small amounts of
inventory, long-term assets, or long-term debt).
Example 1
Act Higher Clinic maintains the accounting records of Act Higher Clinic on a cash basis. During
2015, Act Higher Clinic collected Br.142, 600 from her patients and paid Br.60, 470 in expenses.
At January 1, 2015, and December 31, 2015, she had accounts receivable, unearned service
revenue, accrued expenses, and prepaid expenses as follows. (All long-lived assets are rented.)

January 1, 2015 December 31, 2015

Accounts receivable Br. 11,250 Br. 15,927
Unearned service revenue 2,840 4,111
Accrued expenses 3,435 2,108
Prepaid expenses 1,917 3,232

Instructions
Prepare a schedule that converts Act Higher Clinic’s “excess of cash collected over cash
disbursed” for the year 2015 to net income on an accrual basis for the year 2015.
Solution
Act Higher Clinic
Conversion of Cash Basis to Accrual Basis
For the Year 2015
Excess of cash collected over cash disbursed (Br.142,600 – Br.60,470) Br.82,130
Add increase in accounts receivable (Br.11,250 – Br.15,927) 4,677
Deduct increase in unearned service revenue (Br.2,840 – Br.4,111) (1,271)
Add decrease in accrued expenses (Br.3,435 – Br.2,108) 1,327
Add increase in prepaid expenses (Br.1,917 – Br.3,232) 1,315
Net income on an accrual basis Br.88,178

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 Alternate solution:
Act Higher Clinic
Conversion of Income Statement Data
from Cash Basis to Accrual Basis
For the Year 2015
Cash Adjustments Accrual
Basis Add Deduct Basis
Collections from customers: Br.142,600
–Accounts receivable, Jan. 1 Br.11,250
+Accounts receivable, Dec. 31 Br.15,927
+Unearned service revenue, Jan. 1 2,840
–Unearned service revenue, Dec. 31 4,111
Service revenue Br.146,006
Disbursements for expenses: 60,470
–Accrued liabilities, Jan. 1 3,435
+Accrued liabilities, Dec. 31 2,108
+Prepaid expenses, Jan. 1 1,917
–Prepaid expenses, Dec. 31 3,232
Operating expenses 57,828
Net income—cash basis Br. 82,130
Net income—accrual basis Br. 88,178

Example 2
NET Corp. maintains its financial records on the cash basis of accounting. Interested in securing
a long-term loan from its regular bank, NET Corp. requests you to convert its cash-basis income
statement data to the accrual basis. You are provided with the following summarized data
covering 2014, 2015, and 2016.
2014 2015 2016
Cash receipts from sales:
On 2014 sales Br.290,000 Br.160,000 Br. 30,000
On 2015 sales –0– 355,000 90,000
On 2016 sales 408,000
Cash payments for expenses:
On 2014 expenses 185,000 67,000 25,000
a
On 2015 expenses 40,000 170,000 55,000
b
On 2016 expenses 45,000 218,000
a
Prepayments of 2015 expenses.
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b
Prepayments of 2016 expenses.

Instructions
i. Using the data above, prepare abbreviated income statements for the years 2014 and 2015 on
the cash basis.
ii. Using the data above, prepare abbreviated income statements for the years 2014 and 2015 on
the accrual basis.
Solution
(a) NET Corp.
Income Statement (Cash Basis)
For the Year Ended December 31,
2014 2015
Cash receipts Br.290,000 Br.515,000
Cash payments 225,000 282,000
Net income Br. 65,000 Br.233,000

(b) NET Corp.

Income Statement (Accrual Basis)
For the Year Ended December 31,
2014 2015
Revenues* Br.480,000 Br.445,000
Expenses** 277,000 265,000
Net income Br.203,000 Br.180,000

*2014: Br.290,000 + Br.160,000 + Br.30,000 = Br.480,000

2015: Br.355,000 + Br.90,000 = Br.445,000
**2014: Br.185,000 + Br.67,000 + Br.25,000 = Br.277,000
2015: Br.40,000 + Br.170,000 + Br.55,000 = Br.265,000

Example 3

A summary of operating results for Glory Company for 2014 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 from comparative balance sheets prepared on the accrual basis of
accounting.

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 End of Period
Accounts Dec.31,2013 Dec. 31, 2014
Accounts receivable Br.52400 Br. 48600
Inventories 75000 72100
Short term prepayments 4100 9500
Accounts payable (merchandise suppliers) 32000 37400
Accrued salaries 2800 3200
Acc. Dep.(There were no disposal of plant assets 50000 74000
during 2008)

Instructions
Prepare an income statement for Glory Company for 2014 under:
a. The accrual basis accounting, and
b. The modified cash basis accounting where by operating expenses (other than depreciation)
are computed on the cash basis accounting. Glory’s income is taxed at 45%.

Solution

GLORY CO.
Income statement
For the period ended on December 31, 2014

Accrual Basis Modified Cash Basis

Sales [=466,000+48,600-52,400] Br.462,200 Br.462,200

Cost of Goods Sold:
Inventories, Jan. 1 Br.75,000 Br.75,000
Net Purchases [=268,200+37,400-32,000] 273,600 273,600
Cost of Goods Available for Sale 348,600 348,600
Less: Inventories, Dec. 31 72,100 72,100
Cost of Goods Sold 276,500 276,500
Gross Profit 185,700 185,700
Operating Expenses-AB [=79,400+4,100-
9,500+3,200-2,800+ (74,000-50,000)] 98,400
Operating Expenses-MCB [=79,400+ 103,400
(74,000-50,000)]
Income before taxes 87,300 82,300
Income taxes (45%) 39,285 37,035
Net income Br. 48,015 Br. 45,265