Using the Basic Accounting Equation to Help Students Understand Differences Between the Cash Basis and Accrual

Basis
B Y N E A L VA N Z A N T E , P H . D . , C M A , C F M , C PA , C F E

THE

DIFFERENCES BETWEEN THE CASH BASIS AND ACCRUAL BASIS OF ACCOUNTING ARE

NOT OFTEN DISCUSSED IN ENOUGH DETAIL IN TEXTBOOKS. THERE ARE A FEW WAYS TO HELP STUDENTS UNDERSTAND THE DIFFERENCES AND CONVERSION.

any small businesses and nonprofit organizations maintain their accounting records on a cash basis. Yet generalpurpose financial statements must be reported using the accrual basis, requiring accountants to convert the records. Thus it is important that accounting students understand the differences between the cash basis and accrual basis of accounting and how to convert one to the other. Many introductory-level accounting students find the accrual method difficult to understand, partly because of lack of exposure to the differences between the two methods. Most students who have never taken an accounting course are accustomed to thinking in terms of the cash basis. The conversion of the cash basis to

the accrual basis is represented by a series of adjusting entries. At this point in a students career, he or she is still getting accustomed to the basic accounting equation as well as accounting terminology and procedures. In other words, the transition from the cash basis to the accrual basis is not as straightforward as it could be. The purpose of this article is to outline presentations, give examples, and provide two cases that can be used in introductory financial courses to help students grasp the process of this conversion. Before assigning the first case, the instructor should review the basic accounting equation and expand the equation to focus on differences between the cash basis and accrual basis: Add simple matrices that show the additions and subtractions involved with conversion of the cash basis

M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY

34

WINTER 2013, VOL. 14, NO. 2

each type of cash increase and decrease during class discussion. Use an example of a cash basis income statement and balance sheet to show that cash receipts are considered revenues and that cash payments are considered expenses. The resulting balance sheet consists of two items: cash on the left and owners equity on the right. In other words, there are no other assets or liabilities associated with using a pure cash basis. Students realize that the difference between the cash basis and accrual basis is the treatment of these other assets and liabilities. Next, introduce timing differences. Under the cash E X PA N S I O N O F T H E B A S I C basis, revenue is recognized when cash is collected from A C C O U N T I N G E Q UAT I O N customers and expenses are recognized when they are Before discussing conversion of cash basis financial paid; under the accrual basis, however, revenue is recstatements, review the basics of the accounting equaognized when it is earned and expenses are recognized tion that involve increases and decreases in total assets as they are incurred. Remind students that Generally (see Table 1a). Accepted Accounting Principles (GAAP) require the accrual basis because of the revenue and expense Table 1a: Basic Accounting Equation recognition principles. Assets = Liabilities + Owners Equity Because revenues can be collected before or after Asset Increases: they are earned, the differences between the cash basis + + and accrual basis for revenue recognition purposes are + + represented by amounts in accounts such as accounts Asset Decreases: receivable (collection after revenue is earned) and unearned revenue (collection before revenue is earned). But differences between the cash basis and accrual basis for expense recognition purposes are represented by amounts in accounts such as prepaid After discussing increases and decreases, expand the expenses (payment before expenses are incurred) and equation by splitting the Assets side of the equation various accrued or payable accounts (payment after into Cash and Other Assets (see Table 1b). expenses are incurred). At this point, you can return to Tables 1a and 1b to Table 1b: Expanded Accounting Equation demonstrate how changes in other assets and Cash + Other Assets = Liabilities + Owners Equity liabilities influence the cash basis income and Cash Inflows: accrual basis income. For example, a decrease + in other assets would result in a greater cash + + basis income than accrual basis income; a + + decrease in accounts receivable would also Cash Outflows: create a greater cash basis income because + the amount of cash collected from customers + (cash basis revenue) would be larger than the + amount of charges for services during the year (accrual basis revenue). You can use other examples of changes in other assets and liabilities Table 1b provides a clear picture of how cash inflows to clarify differences as well. and outflows affect other accounts. Present examples of

to the accrual basis. The first case is based on a service organization with no fixed assets; therefore, it focuses on timing differences for revenues and expenses. The second case should be assigned after discussing inventories because it is based on a retail company with fixed assets. It provides exposure to the additional issues of depreciation and the difference between cash paid for merchandise inventory and cost of goods sold (COGS).

M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY

35

WINTER 2013, VOL. 14, NO. 2

FURTHER BREAKDOWN

OF THE

A C C O U N T I N G E Q UAT I O N

Now that the basic foundations are laid out, introduce students to working problems that require converting cash basis records to the accrual basis. In order to make the conversion, students can work with the beginning and ending balances of accounts that represent differences. Before moving on, make sure that students understand how changes in other assets and liabilities impact the conversion and how the effect of the beginning and ending balances of each account should be opposite of one another. Then show the treatment of the beginning and ending balances of an accounts receivable account. Because the beginning balance of accounts receivable represents accrual basis earnings of the prior year, the beginning balance is subtracted from the cash basis revenue when converting to the accrual basis. Likewise, because the ending balance of accounts receivable represents earnings of the current year that will not be collected until the following period (deferred), the ending balance is added to the cash basis revenue. Thus, the beginning and ending balances of each account should be opposite of one another (one added and one subtracted). Similarly, the effects of the beginning and ending balances of unearned revenue are opposite upon conversion as well (ending balance subtracted and beginning balance added). Because accounts receivable is an asset and unearned revenue is a liability, these balances should be treated differently. This leads to a further breakdown of the basic accounting equation (see Table 2a). Table 2a: Converting from Cash to Accrual Operating Income Beginning
Assets (receivables, prepaid expenses) Liabilities (payables, unearned revenues)

ending balance of assets is added while the beginning balance is subtracted. An increase in an asset account would be added, which inverts the matrix (see Table 2b). Table 2b: Converting from Cash to Accrual Operating Income Increase
Assets (receivables, prepaid expenses) Liabilities (payables, unearned revenues)

Decrease

Two approaches can be used to convert cash basis income to accrual basis income. The indirect method, similar to the one used for preparing the operating section of the Statement of Cash Flows, requires the use of information about beginning and ending balances (or increases and decreases) of other assets and liabilities and the addition or subtraction of these amounts to the cash basis income. The direct method, which shows a breakdown of revenues and expenses, requires students to convert both revenues and expenses directly. Thus, when directly converting expenses, prepaid expenses have the same effect on expenses as unearned revenues have on revenues because both represent prepayments (deferrals). Similarly, accounts payable has the same effect on expenses as accounts receivable has on revenues because both represent accruals. When the amount of an expense is calculated, the pluses and minuses in the matrices may appear to be backwards because revenues are additions to income and expenses are subtractions to income. During class discussions, I sometimes present additional matrices (one for revenues, Table 3a, and one for expenses, Table 3b). Table 3a: Converting Cash Basis Revenues to Accrual Basis Revenues Increase Decrease

Ending

Another approach to converting from the cash basis to accrual basis operating income involves working with the changes in the account balances. In Table 2a, the

Assets (receivables) accrual Liabilities (unearned revenues)deferral

M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY

36

WINTER 2013, VOL. 14, NO. 2

Table 3b: Converting Cash Basis Expenses to Accrual Basis Expenses Increase
Assets (prepaid expenses) deferral Liabilities (payables) accrual

$63,600. (See Table 5a for the resulting accrual basis income statement.) Table 5a: Accrual Basis Income Statement
Revenue ($160,000 $5,200 + $6,900 + $1,300 $1,100) $161,900

Decrease

+
Expenses ($97,000 + $1,400 $1,700 $2,800 + $4,400) Net Income 98,300 $63,600

THE FIRST CASE

The first case is based on a service organization with no fixed assets. Thus, we begin without the additional complexity of inventories and depreciation. (See Table 4 for the first case information.) Table 4: Cash Flow of a Service Organization Account Title
Accounts Receivable Unearned Revenue Accrued Expenses Prepaid Expenses

The calculations of revenues and expenses in Table 5a use the beginning and ending account balances, and net income is derived from the changes in the account balances. Another approach involves the first breakdown of the accounting equation and changes in the account balances (see Table 5b). Table 5b: Income Statement Using the Expanded Accounting Equation Other Owners Assets = Liabilities + Equity
$63,000 $1,700 ($200) $1,600 $300 1,700 200 (1,600) 300 $63,600

January 1
$5,200 $1,300 $2,800 $1,400

December 1
$6,900 $1,100 $4,400 $1,700

Inc. (Dec.)
$1,700 ($200) $1,600 $300

Item
Increase Accounts Receivable Decrease Unearned Revenue Increase Accrued Expenses Increase Prepaid Expenses Accrual Basis Income

Cash

Cash Basis Income $63,000

During the year, the professional service company collected $160,000 in revenue and paid $97,000 in expenses. Determine the following: 1. Cash basis operating income 2. Accrual basis revenue 3. Accrual basis expenses 4. Accrual basis operating income Elaborate on the solutions after students have completed the case. For the purpose of this article, the answers are provided without details. Question 1 is easy to answer: ($160,000 $97,000 = $63,000). Questions 2 and 3 involve converting the cash numbers correctly to derive $161,900 and $98,300, respectively. The answer to question 4 is calculated by subtracting answer 3 from answer 2: ($161,900 $98,000 = $63,600). The answer to question 4 can also be calculated by adding and subtracting account balances (or changes in them) to the cash basis operating income. The answer would still be

THE SECOND CASE

Before the second case is assigned (after discussion of inventories), return to the expanded equations and consider the additional factors involved in a retail company that owns depreciable assets. Even though more details are involved, students can still use the same tables to convert the cash basis income into the accrual basis income. When companies have inventories, cost of goods sold is the amount that is paid to merchandise suppliers under the cash basis. Under the accrual basis, however, COGS is the amount of inventory actually sold. Thus, when converting COGS, students must consider both the change in accounts payable and inventory. An example using T-accounts for inventory

M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY

37

WINTER 2013, VOL. 14, NO. 2

and accounts payable, therefore, could be used to show the difference between cash payments for merchandise purchases and COGS. When converting from the cash basis income to accrual basis income, depreciable assets are treated essentially the same as prepaid expenses because depreciable fixed assets represent long-term prepayments (deferrals). Thus, the decrease in a fixed asset by depreciation is treated the same as a decrease in prepaid expenses. Remind students that there is no depreciation on a cash basis income statement because the asset would have been an expense in the year purchased. (See Table 6 for the second case facts.) Table 6: Cash Flow of a Retail Store Account Title
Accounts Receivable Unearned Revenue Accrued Expenses Prepaid Expenses Accounts Payable (for inventory) Merchandise Inventory

question 5 is $31,400. Question 5 can be calculated in two ways: first, by subtracting the answers to questions 3 and 4 from the answer to question 2: ($198,400 ($120,600 + $46,400) = $31,400). Or students can start with the answer to question 1 and add and subtract the account balances (or changes in them), as was done in the first case. Recall that there is a $5,000 decrease in a fixed asset in addition to those changes reflected in the above table. (See Table 7a for the resulting accrual basis income statement.) Table 7a: Accrual Basis Income Statement for a Retail Store
Sales ($200,000 $5,800 + $4,000 + $1,200 $1,000) Cost of Goods Sold (COGS) ($120,000 $6,500 + $7,800 + $8,600 $9,300) 120,600 $ 77,800 $198,400

January 1
$5,800 $1,200 $4,700 $1,600 $6,500

December 31 Inc. (Dec.)

$4,000 $1,000 $4,600 $1,100 $7,800 ($1,800) ($200) ($100)

Gross Profit Operating Expenses (except depreciation) ($41,000 + $1,600 $1,100 $4,700 + $4,600) $41,400 Depreciation 5,000

46,400 Net Income $ 31,400

($500) $1,300

$8,600

$9,300

$700

Similar to the first case, the bottom-line answer could be derived from using the first breakdown of the accounting equation (see Table 7b). Table 7b: Income Statement Using the Expanded Accounting Equation Item
Decrease Accounts Receivable Decrease Unearned Revenue Decrease Accrued Expenses Decrease Prepaid Expenses Increase Accounts Payable Increase Merchandise Inventory Depreciation Accrual Basis Income $700 ($5,000) ($500) $1,300

During the year, the retail store collected $200,000 in revenue, paid $120,000 to suppliers of inventory, and paid $41,000 in other expenses. Depreciation of story equipment totaled $5,000. Determine the following: 1. Cash basis operating income 2. Accrual basis sales 3. Accrual basis cost of goods sold 4. Accrual basis expenses 5. Accrual basis operating income You can elaborate on the solutions in complete detail after students have completed their work. For the purpose of this article, however, the answers are provided without details. The solution to question 1 is easy: ($200,000 $161,000 = $39,000). The answer to question 2 is $198,400; question 3 is $120,600; question 4 is $46,400; and

Cash

Other Owners Assets = Liabilities + Equity

$39,000 ($1,800) ($200) ($100) (1,800) 200 100 (500) (1,300) 700 (5,000) $31,400

Cash Basis Income $39,000

M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY

38

WINTER 2013, VOL. 14, NO. 2

S T U D E N T R E S U LT S

When using these cases in the classroom, I have seen students develop an increased understanding of converting the cash basis to the accrual basis and vice versa. The focus on the differences between the two reporting methods helped their understanding as well. These topics are relevant and helpful for students working on problems associated with determining cash provided by operations on the Statement of Cash Flows; the additions and subtractions involved with reconciling the accrual basis net income with cash provided, however, are the opposite of the illustrations in this article. I Neal VanZante, Ph.D., CMA, CFM, CFE, is also a licensed CPA in Oklahoma, Colorado, and Texas. He is a member of IMAs San Antonio Chapter and can be contacted at (361) 944-8274 or nealvz@stx.rr.com.

M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY

39

WINTER 2013, VOL. 14, NO. 2