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Chapter 2: Problem 40

Suppose that Tina's Frame Shop is anticipating applying for a bank loan in the near future. Although Tina's has been using accrual accounting, the bookkeeper suggests that the firm switch to a cash basis in order to improve its financial picture. Required a. Assuming that the bank requires financial statements on a cash basis, what actions could the bookkeeper and the firm take to report more favorable results under the cash basis? b. How might the bank react when it compares any of Tina's earlier statements under the accrual method with statements that are much more favorable under the cash basis? c. Is Tina's auditor obligated to provide both sets of statements to the bank and explain any differences? Why? d. Now assume that the bank permits either cash or accrual accounting. Is it ethical for Tina's to try to "fool" the bank with statements prepared using the most favorable accounting procedures? Why? e. If you were Tina's bookkeeper, would you expect to be fired if you gave the bank both sets of financial statements? How would this possibility change your views?

Short Answer

Expert verified
The actions that can be taken under cash basis are delaying the payment of bills and speeding up the collection of accounts receivable. The bank might get skeptical if it finds considerable discrepancy between the cash and accrual reports. It's the auditor's responsibility to present both sets of financial statements and explain any discrepancies. While legally permissible, using the most favorable accounting procedures may not be ethically correct. A bookkeeper should consider potential job risk against ethical considerations.

Step by step solution

01

Understanding Accounting Methods

Accrual accounting method reports income when it's earned and expenses when they're billed but not paid. Cash accounting method, on the other hand, reports income when cash is received and expenses when they are physically paid. The firm's decision to switch from accrual to cash basis might be in order to present a better financial image although the real situation might be different.
02

Actions to Improve Financial Outlook

Under cash basis accounting, the company can delay paying its bills to show higher cash balance, or it can collect its accounts receivables faster to gain more cash inflow.
03

Bank's Reaction

The bank might get suspicious if recent financial statements under cash basis are drastically different from previous ones using the accrual method. It might cause the bank to conduct a more rigorous examination of Tina's financial reports.
04

Auditor's Responsibilities

Yes, Tina's auditor is obliged to report both sets of financial statements, and if there are significant discrepancies between accrual and cash basis reports, they are supposed to explain the reasons.
05

Ethical Considerations

Although it is not illegal, it can be argued that trying to 'fool' the bank with financial statements manipulated by changing the accounting method cannot be considered as ethical behavior.
06

Potential Consequences and Decision-Making

As a bookkeeper, providing both sets of financial statements may risk hurting the relationship with Tina and may even risk the job. However, prioritizing ethical considerations should lead to delivering an honest picture of the company's financial situation.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Ethical Accounting Practices
Ethical accounting practices are all about honesty and transparency. In Tina's case, switching from accrual to cash basis accounting to show better results is questionable. The fundamental principle here is to present an honest picture of the firm's financial health. Ethical practices ensure that stakeholders like banks, investors, and employees can trust the financial information they are provided with. If Tina's Frame Shop manipulates the financial statements by switching accounting methods to "fool" the bank, it breaches ethical standards.
  • Honesty: Always provide a true representation of the financial status.
  • Transparency: Be open about the methods and any changes that have been made.
  • Integrity: Maintain strong moral principles in financial reporting.

While it's not illegal to choose the most favorable accounting method, doing so with the intention to mislead crosses ethical boundaries. Ideally, Tina's business should aim for ethical accounting practices to build long-term trust and credibility.
Financial Statement Analysis
Financial statement analysis involves reviewing and evaluating a company's financial reports to make informed decisions. When banks review Tina's statements, they are likely focusing on the business's financial stability and ability to repay loans. Switching between cash and accrual accounting can significantly alter the presentation of a company's financial situation.
  • Consistency: Banks prefer consistency in accounting methods to evaluate trends accurately over time.
  • Transparency: Clearly explain any changes in accounting practices or discrepancies between two sets of statements.
  • Reliability: Provide accurate data that reflects the true financial health.

If Tina issues reports that depict drastically different financial outcomes under different accounting methods, the bank might become suspicious. Analyzing these differences is a part of understanding the stable and true financial condition of the business.
Auditor Responsibilities
Auditors play a crucial role in ensuring the integrity of financial reporting. In Tina's scenario, the auditor needs to ensure that both the cash and accrual basis financial statements are available, providing a comprehensive picture of the business. The discrepancies between the two methods should be clearly explained to stakeholders.
  • Duty to Report: Auditors must present all relevant financial data, ensuring it is understandable and comprehensive.
  • Explanation of Differences: They should detail why financial figures differ under the two methods.
  • Objectivity: Maintain a neutral and unbiased view, prioritizing the accuracy of information.

The auditor is obligated to protect the interests of external parties, like banks, by ensuring they are not misled by selective reporting of financial information. This responsibility is crucial for maintaining trust between all parties involved.

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Most popular questions from this chapter

Executory contracts. a. Discuss the concept of an executory contract. Why might a firm sign such a contract? b. How should such a contract be recorded in the firm's financial statements?

Refer to the T-shirt business first described in Chapter \(1,\) "Financial Accounting and Its Environment."The firm now has a small store near the football stadium to display and sell various sporting goods. During the first week that the shop is open, the following events occur. Should they be recorded in the financial statements of the firm? Why or why not? a. A famous football player gives a signed football to the store owner's daughter. b. The firm received a bill from the Public Service Co. for gas and electricity used by the prior tenants in the store. c. The owner bought three lottery tickets for \(\$ 6\) d. One of the three lottery tickets won \(\$ 150 .\) (In this case, assume that you did not originally record the purchase of the tickets and that the owner did not want to record the winnings.) e. The owner learned that the Super Bowl will be held at the nearby stadium in three years.

Use a balance sheet equation to show how each of the following events would be treated under 1\. the cash basis of accounting and 2\. the accrual basis of accounting. a. Ordered airline tickets, hotel accommodations, and tour guidance from Hugo's U-Go Travel at a cost of \(\$ 5,000\). b. Changed the airline reservation. c. Paid a \(\$ 35\) fee to a travel advisor. d. Paid \(\$ 2,000\) for the airline tickets, room, and tour. e. Arrived at the hotel and checked in. f. Found the room to be next to the hotel laundry and facing the noisy loading zone. Furthermore, the room only had two cheap radios and no television! Asked the hotel manager for a more suitable room. g. Tipped the bellhop \(\$ 5\) after luggage was moved to an upgraded room. h. Charged \(\$ 257\) for meals and telephone calls during the week. i. Upon checking out of the hotel at the end of the week, found a \(\$ 40\) per day (for five days) upgrade charge on the hotel bill. j. Paid for the meals and phone charges on the hotel bill, but denied re sponsibility for the upgrade charges. k. The hotel manager insisted that the upgrade charges were not covered by the prepaid vouchers from Hugo's, and they would be charged to the Visa credit card account number on file with the hotel. 1\. Took vacation film to a photo shop for developing. Charges for developing and printing this film were expected to be \(\$ 45,\) not yet paid. \(\mathrm{m} .\) Paid the \(\$ 45\) two weeks later.

As the staff accountant for Gil's Plumbing, you notice that a \(\$ 1,000\) check is drawn (payable to "Cash") on the third Monday of each month and is charged to miscellaneous expenses. You also notice that a sleazy character with a canvas bag comes into the office on the third Tuesday of each month for a 30 -second meeting with Gil. After inquiring about what the \(\$ 1,000\) check is for and to which account it might more properly be charged, Gil suggests that you should "mind your own business" and just record the expenses where you are told. Required a. What would you guess is really happening in this situation? b. Is the \(\$ 1,000\) properly recorded in Gil's accounts? Why? c. Is this a personal transaction or a business transaction? d. since Gil is the sole owner of the plumbing business, can he do whatever he wants with his money? How would this situation differ if Gil were merely the manager who was making these payments without the owner's knowledge? What should you do in this case? Why?

Use pluses and minuses (or NA for not applicable) to show how the following events should be analyzed using the accounting equation under 1\. the cash basis of accounting and 2\. the accrual basis of accounting. a. signed a contract for the purchase of land. b. Paid a deposit on the land purchase. c. Received money in advance from a customer d. Listed land for sale with a local realtor e. Used equipment, such as a computer, in the business. f. Had a computer repaired; the repair person just leaves a bill, but cannot accept payment for the repair. g. Paid the repair bill. h. Provided services to customers who will not pay until next month. i. Received compliments from customers about excellent customer services. j. Hired a well-trained accountant to prepare financial statements and provide financial advice. (Assume no payments have been made.) k. Collected money from customers who have already been billed. 1\. Employees worked this month, but the payroll (payment) was delayed until the following month. m. Failed to pay suppliers for three months because there is not enough money in the bank. n. Received supplies from a vendor, along with a bill. o. Sold land under a contract for 10 future payments. p. Collected one of the contract payments from the land sale.
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