[Anonymous]

Can somebody explain it to me why cash basis accounting understates income by the net decrease during the accounting period of accrued expenses? and not account receivable? I still dont really understand the conversion from cash basis to accrual. Thanks in advance to those who help me explain this question! i use becker… The answer explains that the income under cash basis is higher than the accrual.

The explanation takes the Sales Accrued-Accrued Exp= Net Income under accrual

and then cash collection-payments= Net income. I thought that means Net income in cash basis overstates accrual basis? Did I just read the question stem wrong?

[Whopper Warrior]

Cash to Accrual can seem tricky but it is very easy. Lets create a hypothetical company “cheap and flimsy”

YR 1 (Cash Basis)

(dr.)Cash 100

(cr.) Sales 100

YR 2 (Accrual Basis)

(dr.) Cash 100

(cr.) Sales 100

(Dr.)Warranty Expense 80

(cr.) Allowance for Warranties 80

As we can see in YR 1 under Cash basis we show income of $100, even though we know our product is very cheap and in YR 2 we will have a lot of returns / warranty costs. Under accrual we recognize this expense immediately and so we only show $20 of income.

So, if accrued expenses decreases that means we recognized MORE expenses in that period…

Example.

YR 2 (Cash Basis)

(dr.) Warrant Expense 90

(cr.) Cash 90

Yr 2 (Accrual Basis)

(dr) Accrued Warranty 80

(dr) Warranty Expense 10

(cr) Cash 90

In YR 2, we show a $90 loss for Cash Basis, but only a 10$ loss under accrual (we recognized $80 in YR 1). For simplicity, I omit Inventory concerns and sales in YR 2. As you can see we end up in the same place, but accrual is more smoother and shows a clearer picture of actual financial performance.

ALL 4 parts passed summer 13
Ethics October 13
Experience (waiting)

Becker Only

[Whopper Warrior]

Cash to Accrual can seem tricky but it is very easy. Lets create a hypothetical company “cheap and flimsy”

YR 1 (Cash Basis)

(dr.)Cash 100

(cr.) Sales 100

YR 2 (Accrual Basis)

(dr.) Cash 100

(cr.) Sales 100

(Dr.)Warranty Expense 80

(cr.) Allowance for Warranties 80

As we can see in YR 1 under Cash basis we show income of $100, even though we know our product is very cheap and in YR 2 we will have a lot of returns / warranty costs. Under accrual we recognize this expense immediately and so we only show $20 of income.

So, if accrued expenses decreases that means we recognized MORE expenses in that period…

Example.

YR 2 (Cash Basis)

(dr.) Warrant Expense 90

(cr.) Cash 90

Yr 2 (Accrual Basis)

(dr) Accrued Warranty 80

(dr) Warranty Expense 10

(cr) Cash 90

In YR 2, we show a $90 loss for Cash Basis, but only a 10$ loss under accrual (we recognized $80 in YR 1). For simplicity, I omit Inventory concerns and sales in YR 2. As you can see we end up in the same place, but accrual is more smoother and shows a clearer picture of actual financial performance.

ALL 4 parts passed summer 13
Ethics October 13
Experience (waiting)

Becker Only

[Whopper Warrior]

Accounts Receivable for Cheap and Flimsy

YR 1 (Cash)

No Entry for Sale

Yr 1 (Accrual)

(dr) Accounts Receivable 100

(cr) Sales 100

As we can see in YR 1, although we have made a sale, Cash basis shows no income because we received no Cash. Accrual Basis we show the sale and accounts recievable.

YR 2 (Cash)

Cash (Dr.) 100

Sales (Cr.) 100

YR 2 (Accrual)

Cash (dr) 100

Accounts Recievable (cr.) 100

In YR 2 we show income of 100 under cash but 0 under accrual because of the accounts receivable difference (a decrease). This is opposite of accrued warranties (a liability).

Under Cash Basis if cash is not effected, generally speaking no journal entry is made. Almost everything is recorded as an expense.

Under Accrual, we accrue things, we show long term assets and liabilities, as well as payables, receivables, and everything else that will benefit / hurt our financial performance regardless it hits our bank account. Remember to do journal entries, the proof is in the pudding.

ALL 4 parts passed summer 13
Ethics October 13
Experience (waiting)

Becker Only

[Whopper Warrior]

Accounts Receivable for Cheap and Flimsy

YR 1 (Cash)

No Entry for Sale

Yr 1 (Accrual)

(dr) Accounts Receivable 100

(cr) Sales 100

As we can see in YR 1, although we have made a sale, Cash basis shows no income because we received no Cash. Accrual Basis we show the sale and accounts recievable.

YR 2 (Cash)

Cash (Dr.) 100

Sales (Cr.) 100

YR 2 (Accrual)

Cash (dr) 100

Accounts Recievable (cr.) 100

In YR 2 we show income of 100 under cash but 0 under accrual because of the accounts receivable difference (a decrease). This is opposite of accrued warranties (a liability).

Under Cash Basis if cash is not effected, generally speaking no journal entry is made. Almost everything is recorded as an expense.

Under Accrual, we accrue things, we show long term assets and liabilities, as well as payables, receivables, and everything else that will benefit / hurt our financial performance regardless it hits our bank account. Remember to do journal entries, the proof is in the pudding.

ALL 4 parts passed summer 13
Ethics October 13
Experience (waiting)

Becker Only

[Anonymous]

Hi Whooper Warrior,

Thanks for the explanation. So, for these reasons we can conclude that income under cash basis is higher than accrual in the period of accrued expenses?. Is that correct? Im dealing with CPA-557 for becker.

The question was: compared to the accrual basis of accounting, the cash basis of accounting understates income by the net decrease during the accounting period of: AR or Accrued Expenses. and the answer was accrued expenses.

Since the cash basis only expense when we spend the cash….

[Anonymous]

Hi Whooper Warrior,

Thanks for the explanation. So, for these reasons we can conclude that income under cash basis is higher than accrual in the period of accrued expenses?. Is that correct? Im dealing with CPA-557 for becker.

The question was: compared to the accrual basis of accounting, the cash basis of accounting understates income by the net decrease during the accounting period of: AR or Accrued Expenses. and the answer was accrued expenses.

Since the cash basis only expense when we spend the cash….

[Whopper Warrior]

correct, if AR was to decrease, that means we collected more then sold and so cash income would be overstated. if AE was to decrease that meant we expensed something already accounted for, except cash didnt account for it, so it expenses it in the wrong period, an understatement

ALL 4 parts passed summer 13
Ethics October 13
Experience (waiting)

Becker Only

[Whopper Warrior]

correct, if AR was to decrease, that means we collected more then sold and so cash income would be overstated. if AE was to decrease that meant we expensed something already accounted for, except cash didnt account for it, so it expenses it in the wrong period, an understatement

ALL 4 parts passed summer 13
Ethics October 13
Experience (waiting)

Becker Only

[Anonymous]

Awesome! thanks so much whooper warrior! you are the cpa warrior! lol

[Anonymous]

Awesome! thanks so much whooper warrior! you are the cpa warrior! lol

[Author]

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