You are a senior manager of a small public accounting firm, Travis & Company. One of your interns is dealing with a disgruntled client, Mr. Kenneth Donaldson, owner of a chemical delivery company. Mr. Donaldson is applying to a bank for a substantial loan to expand his fleet of trucks. The bank requires accrual based financial statements but Mr. Donaldson has always kept the company's records on a cash basis. He does not see the purpose of accrual based statements. On his phone call with your intern, Mr. Donaldson said: "After all, I collect cash from customers, pay my bills in cash, and I am going to pay the bank loan with cash." Mr. Donaldson asked the supervisor of the intern to explain the reason for accrual based statements. Your intern has put Mr. Donaldson's accounting information during the past two years in the following table:
Year 1 Year 2
Amounts billed to customers for services rendered $170,000 $220,000
Cash collected from customers 160,000 190,000
Cash disbursements:
Salaries paid to employees for services during the year 90,000 100,000
Utilities 30,000 40,000
Purchase of insurance policy 60,000 -0-In addition, your intern told you that the company incurred utility costs of $35,000 in year 1, that there were no liabilities at the end of year 2, no anticipated bad debts on receivables, and that the insurance policy covers a three-year period.
After reviewing Mr. Donaldson's accounting information, you are about to write a business memo to Mr. Donaldson. In the memo, you should compare cash-based operating cash flows with accrual-based net income and explain why it is of Mr. Donaldson's benefit to prepare financial statements on accrual basis.