Cash to Accrual Adjustments: Tackling FAR Exam Practice Questions

Converting from the cash basis of accounting to the accrual basis can be quite complex, especially when questions provide the cash paid and received, along with an increase or decrease in your Accounts Receivable (AR) and Accounts Payable (AP) balance. The key is to write out the journal entries under both the cash and accrual basis methods, and then compare the two.

In this article, we will explore a side-by-side example of cash and accrual basis, and work through two practice questions where we begin with cash numbers and then consider given AR and AP balances to determine the accrual basis. Let's get started.

Initially, we'll examine a cash-to-accrual example and detail the entries under the cash method and the accrual method.

A company earns $120,000 of revenue, of which $80,000 is collected in cash. The company's AP balance at the beginning of the year was $12,000, and its end of the year AP balance was $8,000. It expended $20,000 in cash for expenses.

Let's first think about the cash entries. We collected $80,000 in cash. From the cash basis perspective, we simply debit cash for $80,000 and credit revenue for $80,000. Then, we paid out $20,000 in cash for expenses, which translates into a credit to cash of $20,000 and a debit to expenses of $20,000.

Hence, our cash-based net income is the $80,000 revenue minus the $20,000 expenses, equaling $60,000. Now, let's consider the accrual method entries. We received $80,000 in cash, but we actually earned $120,000 of revenue due to the accrual method. We record revenue when we earn it, not when we receive the cash.

This means we had a credit to revenue of $120,000 and a debit to cash of $80,000. Therefore, we must have had a debit to accounts receivable of $40,000. Consequently, we have $120,000 in revenue, whereas the cash basis only had $80,000 of revenue.

For the expenses, the AP balance decreased from $12,000 to $8,000. The way to decrease your AP balance is by paying it off, which implies they paid $4,000 of their AP balance for expenses recorded in a prior period. They're paying $20,000 in cash, but $4,000 was to decrease the AP balance, and the remaining $16,000 was for expenses.

Therefore, they have $120,000 of revenue and only $16,000 of expenses. The accrual basis net income is $104,000.

The key point with AR and AP is that an increase in your AR balance increases your accrual income versus the cash method income, whereas an increase in AP balance decreases your accrual method revenue.

This is because you're then recording a debit to expense and a credit to AP, hence no cash is transacted. It wouldn't be anything recorded as an expense for the cash method, but under the accrual method, it would decrease your net income. It's crucial to note whether the AP and AR balances are increasing or decreasing.

Practice Question 1

Now, let's tackle this practice question which prompts us to find the net income under the accrual basis. We have cash received from customers of $1.5 million and cash paid to suppliers of $900,000. If the question asked for the cash basis net income, it would be $1.5 million minus $900,000, which would equal $600,000.

We're focusing on income under the accrual basis. We see that Accounts Receivable (AR) starts out at $250,000 and then decreases to $220,000. This implies that we collected $30,000 of AR for a revenue item that we recorded in a prior period. Consequently, we had to debit cash of $30,000 and credit AR of $30,000.

From this cash received, $30,000 of it isn't actually revenue under the accrual basis. We need to subtract $30,000 from the $1.5 million as it applies to revenue from a prior period. Next, we look at Accounts Payable (AP). It started with $120,000 and then increased by $30,000.

This translates into a debit to expenses for $30,000 and a credit to AP of $30,000. Although the cash paid was $900,000, we need to increase our expenses by this $30,000 increase. Our expenses are actually $930,000. The revenue was $1.5 million minus this $30,000 adjustment for cash received from a prior period revenue, hence $1,470,000, and our expenses were the $900,000 cash paid plus the $30,000 in expenses that increased our AP to $930,000. Taking $1,470,000 minus $930,000 gives us an accrual basis net income of $540,000.

Practice Question 2

Now, let's look at a similar practice question, but where AR instead of decreasing increases and AP, instead of increasing, decreases. We're still looking for the net income under the accrual basis. We have cash received of $900,000 and cash paid of $500,000.

AR starts at $150,000 and ends at $200,000. This implies that in the year we had an entry for accrual method of a debit to AR of $50,000 and a credit to revenue of $50,000. We need to add this extra $50,000 for the increase of the AR to the $900,000, giving us $950,000 for income.

Looking at the expenses, we paid out $500,000 in cash and AP goes from $100,000 down to $80,000. To decrease AP, which has a credit balance, you need to debit it. That means we debited AP by $20,000 and credited cash by $20,000. In other words, $20,000 of this $500,000 isn't for expenses; it's for paying down AP from expenses from a prior period.

Instead of saying we paid out $500,000, we subtract this from the cash payments to indicate that we only paid out $480,000. Thus, our accrual basis net income is $950,000 minus $480,000, which is $470,000.

I hope cash to accrual adjustments are clearer after this article! Keep learning!