[MacroUniversity]

In order to measure performance for a specific accounting period, it is necessary to measure the amount of revenues and expenses from operating activities that have begun but are not yet complete at the end of the period. There are two ways to measuring operating performance:

• The cash basis of accounting
• The accrual basis of accounting

Cash Basis of Accounting
The firm measures performance as it receives cash from customers and makes cash expenditures to providers of goods and services. Cash receipts from selling goods and providing services are included, on the other hand, financing activities are not included.

Ex: Firm opens a store on Jan 1, 2001. Financing of the store costs $100K in cash. Firm pays two months' rent of $15K in advance. Firm acquires merchandise in January costing $100K of which it purchases $60K for cash and $40K on account for payment in February. Sales to customers during January total $100K of which $80K is for cash and $20K is on account for collection in February and March. Cost of merchandise sold during January was $25K. Firm paid $10K in salaries.

Solution: Recall that firm records sales as it receives cash. Income is cash receipts minus cash disbursements for goods and services. The firm makes $100K sales, but will record performance equal to cash receipts of $80K. The remaining $20K will be recorded as performance when customers pay the amounts owed. Moreover, firm acquired merchandise costing $100K in January, but paid only $60K in cash. Performance measure subtracts only the cash paid. In addition, firm will subtract other cash expenditures during January, including salaries of $10K and rent of $15K, even though this rent also includes payment for February.

Net Cash Inflow (Net Income) = Cash Inflows ($80K) - Cash Outflows ($60K + $10K + $15K) = -$5K

There are three weak points of cash basis of accounting:

• Does not adequately match the cost of the efforts required to generate inflows.
• Separates the recognition of revenue from the process of earning those revenues.
• Performance measurement is sensitive to the timing of cash expenditures. (Rent paid for January and February is recognized immediately while firm would have benefited if it recognized overtime.)

Who uses cash basis of accounting? This type of accounting is often used by individuals for computing personal income and taxes, firms with no medium-term or long-term assets and other professionals and firms who have few or no investments in inventories and collect cash from clients soon after they render services.

Accrual Basis of Accounting
The firm recognizes revenue when it sells goods or renders services, and recognized expenses in the same period as the firm recognizes revenues which the expenses took place in order to generate those underlying revenues.

Ex: The firm has the revenues and expenses outline in the previous example. How will the revenues and expenses be recognized under the accrual basis of accounting?

Solution: The firm will recognize the entire $100K sales in January as revenue, regardless the cash amount it received. Recall that under accrual basis of accounting, sales trigger revenue recognition. The firm also recognizes the merchandise sold in January (cost of goods sold) as $25K. From the advance rent of $15K, the firm only recognizes $7.5K for January. The remaining $7.5K purchases rent benefit for the month of February, hence will appear as an asset on the balance sheet. The salary and rent are expenses for January that the firm consumed as services.

Net Income = Cash Inflows ($100K) - Cash Outflows ($25K + $10K + $7.5) = $57.5K