CPA Exam Review Focal Point (FAR): Converting from Cash to Accrual Accounting
“Converting from Cash Basis to Accrual Basis Accounting” is the first installment in a long series of blog posts geared toward deconstructing the most likely topics you may be tested on when you take the Financial Accounting and Reporting (FAR) section of the Uniform CPA Exam. Candidates are likely to get questions about this topic because the administrators of the exam desire to assess the candidates’ understanding of the differences between cash basis accounting and accrual basis accounting.
With the cash basis of accounting, a revenue item is recorded in the time period in which the related cash is received from the customer and an expense is recorded in the time period in which the related cash is paid. As you may have learned in Introductory Accounting and Intermediate Accounting, cash basis financial record-keeping is not in conformity with generally accepted accounting principles (GAAP). Most companies use the accrual basis of accounting, which requires that a revenue item is reported in the time period in which it is earned and an expense item is reported in the time period in which it is incurred.
In a cash basis accounting system, revenue that is earned during the period but not collected (accrued revenue) is omitted from the accounting records until a collection is made. When converting from cash to accrual, the omitted amount results in an increase in revenues on the income statement and in an increase in accounts receivable on the balance sheet. On the other hand, revenue that has been received but not earned (unearned or deferred revenue) is recorded as revenue. When converting from cash to accrual, the recorded revenue results in a decrease in revenues on the income statement and an increase in liabilities (unearned revenue) on the balance sheet.
In a cash basis accounting system, expense that is incurred but not paid (accrued expense) is omitted from the accounting records until a disbursement is made. When converting from cash to accrual, the omitted amount results in an increase in expenses on the income statement and in an increase in liabilities (payable) on the balance sheet. On the other hand, advance cash disbursements to cover future expenses (prepaid or deferred expense) are recorded as expenses. When converting from cash to accrual, the recorded expense results in a decrease in expenses on the income statement and in an increase in assets (prepaid expense) on the balance sheet.
The following is a table that shows how to adjust cash basis records to arrive at accrual basis records:
|Cash Basis||Adjustments to Cash Basis||Equals Accrual Basis|
|Cash receipts||– Beginning accounts receivable|
+ Ending accounts receivable
+ Beginning unearned revenue
– Ending unearned revenue
|Cash disbursements||– Beginning accounts payable|
+ Ending accounts payable
– Beginning accrued expenses
+ Ending accrued expenses
+ Beginning prepaid expenses
– Ending prepaid expenses
+ Beginning inventory
– Ending inventory
+ Beginning unused supplies
– Ending unused supplies
and Bad Debt Expense. See Note 1)
|Note 1: Non-cash expenses such as depreciation on plant assets, bad debt expense, amortization of|
intangibles, and amortization of discount on notes payable are ignored in the above format. These items would also have to be considered in computing total operating expenses incurred or in computing net income on an accrual basis.
As you may have noticed while reading through this CPA Exam review flashpoint, the process of converting accounting records from cash basis accounting to accrual basis accounting is relatively straight forward. Please be kind to use the the comments section below to share your own tips on this topic, to ask clarifying questions, or to share your views on what was discussed.