|In Chapter 1, we discussed and illustrated the differences between cash and accrual accounting. Cash basis accounting produces a measure called net operating cash flow. This measure is the difference between cash receipts and cash disbursements during a reporting period from transactions related to providing goods and services to customers. On the other hand, the accrual accounting model measures an entity's accomplishments and resource sacrifices during the period, regardless of when cash is received or paid. At this point, you might wish to review the material in Chapter 1 on pages 7 and 8 to reinforce your understanding of the motivation for using the accrual accounting model.|| || (9.0K)||LO8|
Adjusting entries, for the most part, are conversions from cash basis to accrual basis. Prepayments and accruals occur when cash flow precedes or follows expense or revenue recognition.
Accountants sometimes are called upon to convert cash basis financial statements to accrual basis financial statements, particularly for small businesses. You now have all of the tools you need to make this conversion. For example, if a company paid $20,000 cash for insurance during the fiscal year and you determine that there was $5,000 in prepaid insurance at the beginning of the year and $3,000 at the end of the year, then you can determine (accrual basis) insurance expense for the year. Prepaid insurance decreased by $2,000 during the year, so insurance expense must be $22,000 ($20,000 in cash paid plus the decrease in prepaid insurance). You can visualize as follows:
Insurance expense of $22,000 completes the explanation of the change in the balance of prepaid insurance. Prepaid insurance of $3,000 is reported as an asset in an accrual basis balance sheet.
Suppose a company paid $150,000 for salaries to employees during the year and you determine that there were $12,000 and $18,000 in salaries payable at the beginning and end of the year, respectively. What was salaries expense for the year?
Salaries payable increased by $6,000 during the year, so salaries expense must be $156,000 ($150,000 in cash paid plus the increase in salaries payable). Salaries payable of $18,000 is reported as a liability in an accrual basis balance sheet.
Using T-accounts is a convenient approach for converting from cash to accrual accounting.
The debit to salaries expense and credit to salaries payable must have been $156,000 to balance the salaries payable account.
For another example using T-accounts., assume that the amount of cash collected from customers during the year was $220,000, and you know that accounts receivable at the beginning of the year was $45,000 and $33,000 at the end of the year. You can use T-accounts to determine that sales revenue for the year must have been $208,000, the necessary debit to accounts receivable and credit to sales revenue to balance the accounts receivable account.
Now suppose that, on occasion, customers pay in advance of receiving a product or service. Recall from our previous discussion of adjusting entries that this event creates a liability called unearned revenue. Assume the same facts in the previous example except you also determine that unearned revenues were $10,000 and $7,000 at the beginning and end of the year, respectively. A $3,000 decrease in unearned revenues means that the company earned an additional $3,000 in sales revenue for which the cash had been collected in a previous year. So, sales revenue for the year must have been $211,000, the $208,000 determined in the previous example plus the $3,000 decrease in unearned revenue.
Illustration 2–14 provides another example of converting from cash basis net income to accrual basis net income.
Notice a pattern in the adjustments to cash net income. When converting from cash to accrual income, we add increases and deduct decreases in assets. For example, an increase in accounts receivable means that the company earned more revenue than cash collected, requiring the addition to cash basis income. Conversely, we add decreases and deduct increases in accrued liabilities. For example, a decrease in interest payable means that the company incurred less interest expense than the cash interest it paid, requiring the addition to cash basis income. These adjustments are summarized in Graphic 2–5.
Most companies keep their books on an accrual basis.7 A more important conversion for these companies is from the accrual basis to the cash basis. This conversion, essential for the preparation of the statement of cash flows, is discussed and illustrated in Chapters 4 and 21. The lessons learned here, though, will help you with that conversion. For example, if sales revenue for the period is $120,000 and beginning and ending accounts receivable are $20,000 and $24,000, respectively, how much cash did the company collect from its customers during the period? The answer is $116,000. An increase in accounts receivable of $4,000 means that the company collected $4,000 less from customers than accrual sales revenue, and cash basis income is $4,000 less than accrual basis income.
Most companies must convert from an accrual basis to a cash basis when preparing the statement of cash flows.
Cash to Accrual
Converting Cash Basis to Accrual Basis Income
FINANCIAL REPORTING CASE SOLUTION
What purpose do adjusting entries serve?(p. 67) Adjusting entries help ensure that only revenues actually earned in a period are recognized in that period, regardless of when cash is received. In this instance, for example, $13,000 cash has been received for services that haven’t yet been performed. Also, adjusting entries enable a company to recognize all expenses incurred during a period, regardless of when cash is paid. Without depreciation, the friends’ cost of using the equipment is not taken into account. Conversely, without adjustment, the cost of rent is overstated by $3,000 paid in advance for part of next year’s rent.
With adjustments, we get an accrual income statement that provides a more complete measure of a company’s operating performance and a better measure for predicting future operating cash flows. Similarly, the balance sheet provides a more complete assessment of assets and liabilities as sources of future cash receipts and disbursements.
What year-end adjustments are needed to revise the income statement? Did your friends do as well their first year as they thought?( p. 67) Three year-end adjusting entries are needed:
No, your friends did not fare as well as their cash based statement would have indicated. With appropriate adjustments, their net income is actually only $20,000: