Cash vs. Accrual Financial Statements

  Vera F. Lexible is interested in buying Donna’s Aerobic Dance Studio (DADS). She has come to you for an explanation of the financial statements and to seek your advice about purchasing the business.

DADS has been operating for one year. The business is a sole proprietorship owned by Donna Prince. The business rents the building in which it operates, as well as the exercise equipment. As virtually all of the business transactions are in cash payments, Donna has maintained the accounting records on a cash basis. She prepared the following income statement and balance sheet from these cash records at year end, which she gave to Vera. Statement of Receipts and Payments Revenue Membership Fees                                            $150,000 Membership Dues                                               60,000                                                                         $210,000 Expenses Rent                                        18,000 Wages                                                 57,000 Advertising                             20,000 Miscellaneous              15,000              110,000 Net Income                                                     $100,000 Statement of Financial Position Assets Cash                                                                $25,000 Liabilities and Owner’s Equity Donna Prince, Capital                                     $25,000

Donna is offering to sell the business for the balance in her capital account, which she has calculated as $25,000. Vera is very enthusiastic and states, “How can I go wrong? I’ll be paying $25,000 to buy $25,000 cash, and I’ll be getting a very profitable business which generates large amounts of cash in the deal.” In a meeting with you and Vera, Donna makes the following statement: “This business has been very good to me. In my first year of operations, I’ve been able to withdraw $75,000 in cash. Yet the business is still quite solvent – it has lots of cash and no debts”. You ask Donna to explain the difference between membership fees and membership dues. She responds, “Donna’s is an exclusive club. We cater only to members who join up for five years. This year, we sold 500 memberships as soon as we opened for business. Each membership requires the customer to pay a $300 fee (in cash) in advance and to pay membership dues of $10 per month for five years. I credited the advance payments to the Membership Fees revenue account and the $10 monthly payments to Membership Dues revenue. Note that all the revenue is hard cash – no `paper profits’ like you see in so many businesses. No members have dropped out, so Donna’s should continue receiving dues from these people for another four years, thus assuring future profitability. Another beneficial factor is that the company hasn’t sold any new memberships in the last several months. Therefore, I think that the company could discontinue its advertising and further increase future profitability”. Required: Donna’s financial statements were prepared on a cash basis, not an accrual accounting basis. Prepare an Income Statement and a Balance Sheet applying the concepts of accrual accounting.