[lz221476]

Compared to the accrual basis of accounting, the cash basis of accounting understates income by the net decreases during the accounting period of:

Account receivable Accrued expenses

a. yes yes

b. yes no

c. no no

d. no yes

Right answer is D. I chose A. My explanation: “Cash basis of accounting understates income”, because it might miss some income which has happened but didn’t receive cash yet, and some expense which has happened may hasn’t been paid yet. So account receivable and accrued expenses both were understated. Anyone can help me find my mistake?

[Iron_Victory]

If a receivable decreases then we got some cash in our hot little hand and we recognize the revenue. No understatement.

If a payable decreases then we paid some cash out and we recognize and expense BUT compared to accrual basis we are understating our income for the period because of the matching principle.

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[M.O.D.]

Under the cash basis of accounting, income is recognized if cash is received. There is no AR account whatsoever.

Try doing sample transactions with both methods. There is no difference in income whether you post to Cash or to AR.

But if you never post Accrued expenses, there is a difference.

BA Mathematics, UC Berkeley
Certificates in CPA and EA preparation, College of San Mateo
CMA I 420, II 470
FAR 91, AUD Feb 2015 (Gleim self-study)

[NYCaccountant]

Accrual Cash 1,000

AR. 2,000 3,000 overstated Answer is no

Acr. exp 2,000 3,000 1,000 Answer is yes.

Understated

Basically under accrual accounting, if our AR was 2,000 but we collected 3,000 of cash, we would have a 1,000 net increase if we chose cash basis, so we know that is wrong.

If we paid 3,000 worth of expenses, but only accrued 2,000 we would have a net 1,000 decrease in income under cash basis.

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[Anonymous]

Here's a simple way to think about it: Under the indirect method of preparing the statement of cash flows, we start with Net Income (accrual basis) and among other things, we subtract decreases in liabilities and add decreases in A/R to arrive at Cash Basis Net Income.

So if you flip the script and say, under Cash Basis, if A/R and Accrued Expenses both went DOWN, what would I have to do to get to accrual basis? In that case, you would have to subtract the decrease in A/R and add back the decrease in the accrued expense account. So knowing that, is income under cash basis understated by a decrease in A/R? No, because a net decrease in A/R would imply that we collected more from our customers than we billed for the month, which would mean our cash basis income would by higher than our accrual basis for the month. Is income under cash basis understated by a decrease in accrued expenses? Yes, because a net decrease in accrued expenses implies that we paid more cash to settle our accrued expense obligations than we incurred during the period, which would ultimately drive cash basis income lower during the period (thus, being understated).

I know I rambled a lot, but hopefully that explains why the answer is “No; Yes”.

[Whopper Warrior]

accounts receivable…

cash basis

(d) cash 100

(c) revenue 100

accrual basis

(d) cash 100

(c) accounts receivable 100

cash basis revenue 100, accrual revenue 0. overstated revenue when a/r decreases. Cash basis understates revenue when cash is not recieved for services performed.

accrued expenses…

cash basis

(d) expense 100

(c) cash 100

accrual

(d) accured expense (aka a payable) 100

(c) Cash 100

cash basis 100 expense, accrual 0; understates. under cash basis we overstated revenue py when an expense or liability was incurred without recognition.

when in doubt, do some low level je's. The proof is in the debits/credits.

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[M.O.D.]

I have a different interpretation.

Cash basis:

Dr. cash 100

Cr. revenue 100

Accrual basis:

Dr. AR 100

Cr. Revenue 100

No difference in revenue: neither overstated nor understated

Income so far is 100 for both

Accrued expenses:

Cash basis

No Entry due to not accruing

Accrual basis

Dr. Expense 100

Cr. AP 100

The cash basis income is 100, the Accrual income is 0 (because the expense was incurred).

BA Mathematics, UC Berkeley
Certificates in CPA and EA preparation, College of San Mateo
CMA I 420, II 470
FAR 91, AUD Feb 2015 (Gleim self-study)

[Whopper Warrior]

@mod on december 31, 20XX CVA company shoveled the driveway for a little old lady. The lady forgetting she had no cash in her wallet gave CVA an IOU (accounts receivable) for the next time CVA comes to shovel her driveway. This is the only driveway shoveled during the year, and CVA closes its books at midnight on December 31, 20XX. What is revenue for CVA for Cash basis Vs Accrual Basis.

Cash

no cash recieved, no je. Services were performed but because no cash we do not recognize revenue.

Accrual

(d) accounts receivable 100

(c) sales 100

On January 5th, CVA company is in dire need of cash for a new shovel chipping it on snowmagedon ice and collects little old ladys 100 IOU. What are the journal entries for CVA on a Cash vs Accrual basis? @mod, can you finish? I have to go make hot chocolate just thinking about shoveling snow…

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[M.O.D.]

@WW

I am not sure a cash company would accept IOUs. But even if they did collect on an unrecorded IOU in year 2, that would be year 2 revenue, though the service was provided in year 1. This lack of matching is why cash basis is non-GAAP.

So year 2 would be:

Cash basis:

Dr. Cash 100

Cr. Sales 100

Accrual basis would be:

Dr. Cash 100

Cr. AR 100

But the question is for transactions “during the accounting period.” Why complicate it by jumping periods.

BA Mathematics, UC Berkeley
Certificates in CPA and EA preparation, College of San Mateo
CMA I 420, II 470
FAR 91, AUD Feb 2015 (Gleim self-study)

[mla1169]

A decrease in A/R means an increase in another balance sheet account (usually cash, but could also be allowance for doubtful accounts) since that decrease stays on the balance sheet it wouldn't affect net income (your P&L).

But a decrease to accrued expenses is offset on the P&L. Therefore a decrease in accrued expenses means that something that would have reduced net income via accrual in a previous period actually reduces (and understates) income in the current period.

And yes companies on the cash basis accept payment after delivery of goods/services all the time. Don't confuse cash basis with COD.

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[M.O.D.]

@ mla

So are you saying that the premise of the question is that a company:

1) is currently using accrual basis

2) wants to see whether the cash basis would understate income, so it

3) decreases AR

4) decreases accrued expenses (a liability account of expenses “recognized”/accrued in a prior period)

I agree that reducing AR has no effect because revenue was already recognized.

But you are saying that undoing the accrual (to convert to a cash basis) requires the company to restate the prior period's expenses. This would overstate the prior period's cash income. And it would thus understate this period's income as expenses are incurred due to them having to be paid in cash.

It is logical, but it requires the assumption that the accrued expenses must be paid out this period in cash. What if the expense need not be paid until period 3.

There is also the issue of reducing/ “decreasing” AR by paying it off. Why not reduce accrued “decrease” accrued expenses the same way. Then it would likewise have no effect on P/L.

I think the question expects us to undo the revenue for prior year as well and that would understate prior year's revenue and overstate this period's revenue. But since the question asks for “understate” it is a “no” answer.

I think it is a very poorly worded question, especially since it is asking “during the accounting period”. It makes me think of Dec 31, and having completed the accruals and the revenue recognition and having to undo those. Then the answer would be the exact opposite. Decrease in AR would lower income thus understating it, and decrease in expenses would increase income, thus overstating it.

BA Mathematics, UC Berkeley
Certificates in CPA and EA preparation, College of San Mateo
CMA I 420, II 470
FAR 91, AUD Feb 2015 (Gleim self-study)

[Whopper Warrior]

@mod, for a net decrease in a/r we need to have an a/r on the b/s at the start of the year. How can we have a net decrease of an account if there was no beginning balance? if we had a/r and received a/r in the same period: cash equals accrual for that period. Again if we accrued the expense and paid the expense in the same period, cash equals accrual for that transaction in that period.

@mla, I am confused by your explination. You are explaining a/r has no p/l impact but an accrued expense (a payable) does. as i understand:

d

yr 1

cash no entry

accrual intrest expense 100

intrest payable (accrued intrest, whatever) 100

yr 1 expense of 0 for cash, and 100 for accrual.

yr 2,

cash

intrest expense 100

cash 100

accrual

intrest payable 100

cash 100

here we see cash overstates in yr 1, and understates in yr 2.

for a receivable we understate in yr 1, and overstate in yr 2.

If this is not the case…why are these je's wrong? what would cash/accrual do different?

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[M.O.D.]

@WW

I think we need to first clarify which period(s) the question is addressing.

BA Mathematics, UC Berkeley
Certificates in CPA and EA preparation, College of San Mateo
CMA I 420, II 470
FAR 91, AUD Feb 2015 (Gleim self-study)

[Whopper Warrior]

y2, when the decrease happens.

ALL 4 parts passed summer 13
Ethics October 13
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[M.O.D.]

If there are balances carried over from year 1 and the decreases are made in year 2, we are mostly in agreement.

How do you get that from the question though?

BA Mathematics, UC Berkeley
Certificates in CPA and EA preparation, College of San Mateo
CMA I 420, II 470
FAR 91, AUD Feb 2015 (Gleim self-study)

[mla1169]

One transaction that would reduce accounts receivable (accrual basis) is the receipt of cash. That same transaction using the cash basis would increase revenue so we can rule out the notion that it could understate net income.

One transaction that could reduce accrued expenses is receiving an invoice from a vendor and paying it. Under the cash method that same transaction would increase expenses. An increase in expenses can mean net income understates (remember the question asks in COMPARISON).

FAR- 77
AUD -49, 71, 84
REG -56,75!
BEC -75

Massachusetts CPA (non reporting) since 3/12.

[Author]

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