Financial Accounting: An Integrated Statements Approach, 2nd Edition

Family Health Care Under the Cash and Accrual

Bases of Accounting

All the transactions for Family Health Care in Chapter 2 involved the receipt or pay-

ment of cash. As a result, the financial statements shown in Chapter 2 for Family

Health Care would be the same as that reported under the cash basis of accounting. In

this chapter, however, Family Health Care entered into transactions that used accrual

accounting concepts. As a result, the November financial statements shown in Exhibits 3

through 6 differ from those prepared using the cash basis of accounting.

One of the major differences in financial statements prepared under the accrual

and cash bases of accounting involves the reporting of net income and net cash flows

from operations. Under the cash basis of accounting, net income and net cash

flows from operations are the same. For example, in Chapter 2, net income and net

cash flows from operations for September and October for Family Health Care were

$2,600 and $3,220. In contrast, under the accrual basis of accounting, net income and

net cash flows from operations may be significantly different. This is shown in Exhibit

3 where Family Health Care reports net income of $6,390 for November while report-

ing net cash flows from operations of ($1,690). This difference is due to the effects of

accrual and deferrals.^2

Importance of Accrual Basis of Accounting

The use of the accrual basis of accounting is essential for assessing and interpreting the

financial performance of an entity. To illustrate, we have summarized the net cash

flows from operations and net income for Family Health Care below.

Net Cash Flow

from Operations Net Income

September $ 2,600 $2,600

October 3,220 3,220

November (1,690) 6,390

Under the cash basis, the cash flows from operating activities and the net income

for November would be reported as a negative amount (loss) of $1,690. While this

might be interpreted as an unfavorable trend, the accrual basis better reflects what is

really happening to Family Health Care. Since September, revenues have more than

doubled, increasing from $5,500 to $12,350, and net income has more than doubled.

Thus, the accrual basis reflects Family Health Care as a profitable, rapidly expanding

business. This illustrates why net income is generally a better predictor of the long-

term profitability of a business than is net cash flows from operations.

Such differences between the cash basis and the accrual basis illustrate why gener-

ally accepted accounting principles require the accrual basis for all but the very

smallest businesses. You should recognize, however, that the net cash flow from op-

erating activities is an important amount that is useful to readers of the financial state-

ments. For this reason, generally accepted accounting principles require reporting

cash flows. For example, in the long run, a business will go bankrupt if it continually

118 Chapter 3 Accrual Accounting Concepts

2 A formal reconciliation of net cash flows from operations and the net income is shown in the appendix

at the end of this chapter.