Exhibit 6.

Cash basis versus Accrual basis of accounting

Donald and Joanne Allens open a hardware store on January 1, Year 1. The firm receives
$20,000 in cash from the Allens and borrows $12,000 from a local bank. It must repay
the loan on June 30, Year 1, with interest charged at the rate of 12 percent per year. The
firm rents a store building on January 1 and pays two months’ rent of $4,000 in advance.
On January 1, it also pays the premium of $2,400 for property and liability insurance
coverage for the year ending December 31, Year 1. During January it acquires
merchandise costing $40,000 of which it purchases $26,000 for cash and $14,000 on
account. Sales to customers during January total $50,000, of which $34,000 is for cash
and $16,000 on account. The acquisition cost of the merchandise sold during January is
$32,000, and various employees receive $5,000 in salaries.
(Note that the income statement does not include cash received from owners or from
borrowing. These items are neither revenues nor expenses, but financing transactions.)
Under the cash basis of accounting a firm recognizes revenues from selling goods and
providing services, in the period when it receives cash from customers. It reports
expenses in the period when it makes cash payments for merchandise, salaries, insurance,
taxes, and similar items.

The accrual basis of accounting recognizes revenue when a firm sells goods and renders
services. Cash from customers could be received earlier, at the time of sale, or later.
Expenses are the use of resources in the period when a firm recognizes the revenues that
the costs helped to produce.
The accrual concept attempts to match expenses with associated revenues.
The accrual basis of accounting provides a better measure of operating performance than
does the cash basis for two reasons:
 Revenues more accurately reflect the results of sales activity of the period
 Expenses more closely match reported revenues
It focuses on inflows of net assets from operations (revenues) and the use of net assets in
operations (expenses), independent of whether those inflows and outflows currently
produce or use cash.
Timing and criteria of revenue recognition under accrual basis of accounting:
 A firm has performed all, or a substantial portion of the services
 A firm has received cash, a receivable, or some other asset capable of reasonably
precise measurement
Measurement of revenue:
 Uncollectible accounts
If a firm expects not to collect some portion of the sales for a period, it must
adjust the amount of revenue recognized in the same period.
 Sales discounts and allowances
Customers may take advantage of discounts for prompt payment, and the seller
may grant allowances for unsatisfactory merchandise. The seller must estimate
these amounts and make appropriate reductions, at the time of sale, in measuring
the amount of revenue it recognizes.
 Sales returns
A firm must estimate the expected returns and make appropriate reductions in
revenue measured at the time of sale.

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Timing and criteria of expense recognition under accrual basis of accounting:
 If an asset expiration associates directly with a particular revenue, that expiration
becomes an expense for the period when the firm recognizes the revenue (for
example the cost of goods sold).
 If an asset expiration does not clearly associate with revenues, that expiration
becomes an expense for the period (for example marketing and administrative
expenses).

Allens’ Hardware Store, Performance Measurement for the Month of January, Year 1
(Cash Basis of Accounting)
Cash Receipts from Sales of Merchandise $34,000
Less: Cash Expenditures for Merchandise and Services
Merchandise $26,000
Salaries 5,000
Rent 4,000
Insurance 2,400
Total Cash Expenditures 37,400
Excess of Cash Expenditures over Cash Receipts ($3,400)

Allens’ Hardware Store, Income Statement for the Month of January, Year 1
(Accrual Basis of Accounting)
Sales Revenue $50,000
Less: Expenses
Cost of Goods Sold $32,000
Salaries 5,000
Rent 2,000
Insurance 200
Interest 120
Total Expenses 39,320
Net Income $10,680

Relation between balance sheet and income statement:

Assets = Liabilities + Shareholders’ Equity
Shareholders’ Equity = Contributed Capital + Retained Earnings
Retained Earnings = Retained earnings at beginning of period
+ Net income for the period (Income statement item)
- Dividend for the period
Net income = Retained Earnings at the end of period
- Retained earnings at beginning of period
+ Dividend

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The use of T-accounts:
Individual revenue and expense accounts are used during the accounting period. These
accounts, unlike balance sheet accounts, begin the accounting period with zero balance.
 Expense accounts
Increase on the debit side
Decrease on the credit side
 Revenue accounts
Increase on the credit side
Decrease on the debit side
 If the aggregated balance of the revenue and expense accounts is a credit balance,
it is the net income.
 If the aggregated balance of the revenue and expense accounts is a debit balance,
it is the net loss

Trial balance
A trial balance lists all accounts in the general ledger and their debit or credit balances. It
does not prove the complete accuracy of the accounting records. Some transactions are
not recorded during the period, and other events will be recorded after the preparation of
the unadjusted trial balance.
Errors not shown in the trial balance:
 Error of omission
 Reversal entries
 Misposted entry
 Double recording the same event

Exhibit 8. illustrates the use of trial balance along with adjusting entries on page 4/7.

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