In this video, we walk through 5 FAR practice questions teaching the calculations for converting cash basis financials to accrual basis. These questions are from FAR content area 1 on the AICPA CPA exam blueprints: Financial Reporting.
The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.
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Converting Cash Basis Financials to Accrual Basis
When converting from cash basis accounting to accrual basis, it’s essential to grasp how various accounts like receivables and payables impact income reporting. We’ll break down the essential rules for converting from cash to accrual, focusing on three pillar topics: how to treat increases and decreases in receivables and payables, and the differences between cash and accrual accounting when it comes to revenue and expenses. We’ll also touch on how converting from modified cash basis to accrual differs from the pure cash basis to accrual conversion.
Treatment of Increases and Decreases in Accounts Receivable (AR)
Accounts Receivable refers to revenue that has been earned but not yet collected in cash. When converting from cash to accrual basis accounting, here’s how you treat changes in AR:
- Increase in AR: When AR increases, it means that more revenue was earned but hasn’t been collected in cash. Under cash basis, you wouldn’t recognize this revenue because no cash has been received yet. But in accrual accounting, you recognize revenue when earned, so an increase in AR is added to cash basis income when converting to accrual.
- Decrease in AR: A decrease means that cash has been received for revenue that was recognized in a prior period. Since this cash was already recognized as revenue under accrual, you subtract a decrease in AR from cash basis income.
Example:
If AR at the beginning of the year is $50,000 and at the end of the year is $70,000, that $20,000 increase represents revenue earned but not yet collected, so you would add $20,000 to your cash basis net income to convert to accrual.
Treatment of Increases and Decreases in Accounts Payable (AP)
Accounts Payable refers to expenses that have been incurred but not yet paid in cash. Here’s how to treat changes in AP during the conversion:
- Increase in AP: An increase means that more expenses were incurred but not yet paid. Under accrual accounting, you record expenses when incurred, so an increase in AP is subtracted from cash basis income when converting to accrual.
- Decrease in AP: A decrease indicates that expenses incurred in a prior period were paid during the current period. Since these expenses were already recognized in the past, a decrease in AP is added to cash basis income during the conversion.
Example:
If AP at the beginning of the year is $30,000 and at the end of the year is $20,000, that $10,000 decrease reflects cash paid for previously incurred expenses. You would add $10,000 to your cash basis income to account for the reduction in liabilities when converting to accrual.
Converting Cash Sales to Accrual Sales
When converting sales from cash basis to accrual, you adjust based on changes in receivables:
- Add increases in receivables: This reflects revenue earned but not yet collected in cash.
- Subtract decreases in receivables: This reflects cash received for revenue that was already recognized.
Example:
If you made $100,000 in credit sales but only collected $60,000 in cash by year-end, under cash basis you would only recognize the $60,000. Under accrual, you would recognize the full $100,000 as sales, adding the $40,000 difference (the increase in AR) to convert from cash to accrual.
The Difference Between Cash and Accrual for Revenue and Expenses
Cash basis accounting recognizes revenue and expenses only when cash changes hands, while accrual basis accounting recognizes them when they are earned or incurred, regardless of when cash is exchanged.
- Revenue: In accrual, revenue is recognized when it is earned, not when cash is received. For example, if you provided services in December but didn’t get paid until January, accrual accounting would still record the revenue in December.
- Expenses: Similarly, expenses are recognized when they are incurred, not when they are paid. If you receive an invoice in November but pay it in January, accrual accounting recognizes the expense in November.
Example:
Imagine your cash basis income is $300,000 for the year, but you’ve earned an additional $50,000 in sales on credit that hasn’t yet been collected. Meanwhile, you incurred $20,000 in expenses that haven’t been paid yet (AP). To convert to accrual:
- Add the $50,000 in earned but uncollected sales.
- Subtract the $20,000 in unpaid expenses.
This makes your accrual basis income $300,000 + $50,000 – $20,000 = $330,000.
Modified Cash Basis vs. Cash Basis in Conversions
When converting from modified cash basis to accrual, there are fewer adjustments needed compared to converting from pure cash basis. Modified cash basis already includes some accrual components, like recognizing long-term assets and liabilities (e.g., capital expenditures or depreciation). Thus, when converting to accrual from modified cash basis, you typically only adjust for short-term items like accounts receivable, accounts payable, and deferred revenue.
Example: If you’re already recognizing depreciation under modified cash basis, you wouldn’t need to adjust for it during the conversion to accrual, unlike with pure cash basis where you would.
Conclusion
Converting from cash basis to accrual involves adjusting for changes in receivables and payables, ensuring that income and expenses are recognized when earned or incurred. Whether you’re adjusting for sales on credit, deferred revenue, or expenses incurred but unpaid, the fundamental rules apply.
