34 MA N A G E ME N T A C C O U N T I N G Q U A R T E R L Y WI N T E R 2 0 1 3 , V O L . 1 4 , N O .

2
M
any small businesses and nonprofit
organizations maintain their accounting
records on a cash basis. Yet general-
purpose financial statements must be
reported using the accrual basis,
requiring accountants to convert the records. Thus it is
important that accounting students understand the dif-
ferences between the cash basis and accrual basis of
accounting and how to convert one to the other.
Many introductory-level accounting students find the
accrual method difficult to understand, partly because
of lack of exposure to the differences between the two
methods. Most students who have never taken an
accounting course are accustomed to thinking in terms
of the cash basis. The conversion of the cash basis to
the accrual basis is represented by a series of adjusting
entries. At this point in a students career, he or she is
still getting accustomed to the basic accounting equa-
tion as well as accounting terminology and procedures.
In other words, the transition from the cash basis to the
accrual basis is not as straightforward as it could be.
The purpose of this article is to outline presenta-
tions, give examples, and provide two cases that can be
used in introductory financial courses to help students
grasp the process of this conversion. Before assigning
the first case, the instructor should review the basic
accounting equation and expand the equation to focus
on differences between the cash basis and accrual
basis: Add simple matrices that show the additions and
subtractions involved with conversion of the cash basis
Using the Basic
Accounting Equation
to Help Students
Understand Differences
Between the Cash Basis
and Accrual Basis
THE DIFFERENCES BETWEEN THE CASH BASIS AND ACCRUAL BASIS OF ACCOUNTING ARE
NOT OFTEN DISCUSSED IN ENOUGH DETAIL IN TEXTBOOKS. THERE ARE A FEW WAYS TO
HELP STUDENTS UNDERSTAND THE DIFFERENCES AND CONVERSION.
B Y NE A L VA N Z A N T E , P H . D. , C MA , C F M, C PA , C F E
35 MA N A G E ME N T A C C O U N T I N G Q U A R T E R L Y WI N T E R 2 0 1 3 , V O L . 1 4 , N O . 2
to the accrual basis. The first case is based on a service
organization with no fixed assets; therefore, it focuses
on timing differences for revenues and expenses. The
second case should be assigned after discussing inven-
tories because it is based on a retail company with
fixed assets. It provides exposure to the additional
issues of depreciation and the difference between cash
paid for merchandise inventory and cost of goods sold
(COGS).
EXPANSI ON OF THE BASI C
ACCOUNTI NG EQUATI ON
Before discussing conversion of cash basis financial
statements, review the basics of the accounting equa-
tion that involve increases and decreases in total assets
(see Table 1a).
Table 1a: Basic Accounting Equation
After discussing increases and decreases, expand the
equation by splitting the Assets side of the equation
into Cash and Other Assets (see Table 1b).
Table 1b: Expanded Accounting Equation
Table 1b provides a clear picture of how cash inflows
and outflows affect other accounts. Present examples of
each type of cash increase and decrease during class dis-
cussion. Use an example of a cash basis income statement
and balance sheet to show that cash receipts are consid-
ered revenues and that cash payments are considered
expenses. The resulting balance sheet consists of two
items: cash on the left and owners equity on the right. In
other words, there are no other assets or liabilities associ-
ated with using a pure cash basis. Students realize that
the difference between the cash basis and accrual basis is
the treatment of these other assets and liabilities.
Next, introduce timing differences. Under the cash
basis, revenue is recognized when cash is collected from
customers and expenses are recognized when they are
paid; under the accrual basis, however, revenue is rec-
ognized when it is earned and expenses are recognized
as they are incurred. Remind students that Generally
Accepted Accounting Principles (GAAP) require the
accrual basis because of the revenue and expense
recognition principles.
Because revenues can be collected before or after
they are earned, the differences between the cash basis
and accrual basis for revenue recognition purposes are
represented by amounts in accounts such as accounts
receivable (collection after revenue is earned) and
unearned revenue (collection before revenue is
earned). But differences between the cash basis and
accrual basis for expense recognition purposes are rep-
resented by amounts in accounts such as prepaid
expenses (payment before expenses are incurred) and
various accrued or payable accounts (payment after
expenses are incurred).
At this point, you can return to Tables 1a and 1b to
demonstrate how changes in other assets and
liabilities influence the cash basis income and
accrual basis income. For example, a decrease
in other assets would result in a greater cash
basis income than accrual basis income; a
decrease in accounts receivable would also
create a greater cash basis income because
the amount of cash collected from customers
(cash basis revenue) would be larger than the
amount of charges for services during the
year (accrual basis revenue). You can use
other examples of changes in other assets and liabilities
to clarify differences as well.
Assets = Liabilities + Owners Equity
Asset Increases:
+ +
+ +
Asset Decreases:


Cash + Other Assets = Liabilities + Owners Equity
Cash Inflows:
+
+ +
+ +
Cash Outflows:
+
+
+
36 MA N A G E ME N T A C C O U N T I N G Q U A R T E R L Y WI N T E R 2 0 1 3 , V O L . 1 4 , N O . 2
FURTHER BREAKDOWN OF THE
ACCOUNTI NG EQUATI ON
Now that the basic foundations are laid out, introduce
students to working problems that require converting
cash basis records to the accrual basis. In order to make
the conversion, students can work with the beginning
and ending balances of accounts that represent differ-
ences. Before moving on, make sure that students
understand how changes in other assets and liabilities
impact the conversion and how the effect of the begin-
ning and ending balances of each account should be
opposite of one another. Then show the treatment of
the beginning and ending balances of an accounts
receivable account. Because the beginning balance of
accounts receivable represents accrual basis earnings of
the prior year, the beginning balance is subtracted from
the cash basis revenue when converting to the accrual
basis. Likewise, because the ending balance of accounts
receivable represents earnings of the current year
that will not be collected until the following period
(deferred), the ending balance is added to the cash
basis revenue. Thus, the beginning and ending bal-
ances of each account should be opposite of one
another (one added and one subtracted).
Similarly, the effects of the beginning and ending
balances of unearned revenue are opposite upon con-
version as well (ending balance subtracted and begin-
ning balance added). Because accounts receivable is
an asset and unearned revenue is a liability, these bal-
ances should be treated differently. This leads to a
further breakdown of the basic accounting equation
(see Table 2a).
Table 2a: Converting from Cash
to Accrual Operating Income
Another approach to converting from the cash basis
to accrual basis operating income involves working with
the changes in the account balances. In Table 2a, the
ending balance of assets is added while the beginning
balance is subtracted. An increase in an asset account
would be added, which inverts the matrix (see Table
2b).
Table 2b: Converting from Cash
to Accrual Operating Income
Two approaches can be used to convert cash basis
income to accrual basis income. The indirect method,
similar to the one used for preparing the operating sec-
tion of the Statement of Cash Flows, requires the use of
information about beginning and ending balances (or
increases and decreases) of other assets and liabilities
and the addition or subtraction of these amounts to the
cash basis income. The direct method, which shows a
breakdown of revenues and expenses, requires students
to convert both revenues and expenses directly. Thus,
when directly converting expenses, prepaid expenses
have the same effect on expenses as unearned revenues
have on revenues because both represent prepayments
(deferrals). Similarly, accounts payable has the same
effect on expenses as accounts receivable has on rev-
enues because both represent accruals.
When the amount of an expense is calculated, the
pluses and minuses in the matrices may appear to be
backwards because revenues are additions to income and
expenses are subtractions to income. During class discus-
sions, I sometimes present additional matrices (one for
revenues, Table 3a, and one for expenses, Table 3b).
Table 3a: Converting Cash Basis Revenues
to Accrual Basis Revenues
Beginning Ending
Assets (receivables, +
prepaid expenses)
Liabilities (payables, +
unearned revenues)
Increase Decrease
Assets (receivables) +
accrual
Liabilities (unearned +
revenues)deferral
Increase Decrease
Assets (receivables, +
prepaid expenses)
Liabilities (payables, +
unearned revenues)
37 MA N A G E ME N T A C C O U N T I N G Q U A R T E R L Y WI N T E R 2 0 1 3 , V O L . 1 4 , N O . 2
Table 3b: Converting Cash Basis Expenses
to Accrual Basis Expenses
THE FI RST CASE
The first case is based on a service organization with no
fixed assets. Thus, we begin without the additional
complexity of inventories and depreciation. (See Table 4
for the first case information.)
Table 4: Cash Flow of a Service Organization
During the year, the professional service company
collected $160,000 in revenue and paid $97,000 in
expenses. Determine the following:
1. Cash basis operating income
2. Accrual basis revenue
3. Accrual basis expenses
4. Accrual basis operating income
Elaborate on the solutions after students have com-
pleted the case. For the purpose of this article, the
answers are provided without details. Question 1 is easy
to answer: ($160,000 $97,000 = $63,000). Questions 2
and 3 involve converting the cash numbers correctly to
derive $161,900 and $98,300, respectively. The answer
to question 4 is calculated by subtracting answer 3 from
answer 2: ($161,900 $98,000 = $63,600). The answer
to question 4 can also be calculated by adding and sub-
tracting account balances (or changes in them) to the
cash basis operating income. The answer would still be
$63,600. (See Table 5a for the resulting accrual basis
income statement.)
Table 5a: Accrual Basis Income Statement
The calculations of revenues and expenses in
Table 5a use the beginning and ending account bal-
ances, and net income is derived from the changes in
the account balances. Another approach involves the
first breakdown of the accounting equation and changes
in the account balances (see Table 5b).
Table 5b: Income Statement Using the Expanded
Accounting Equation
THE SECOND CASE
Before the second case is assigned (after discussion of
inventories), return to the expanded equations and con-
sider the additional factors involved in a retail company
that owns depreciable assets. Even though more details
are involved, students can still use the same tables to
convert the cash basis income into the accrual basis
income. When companies have inventories, cost of
goods sold is the amount that is paid to merchandise
suppliers under the cash basis. Under the accrual basis,
however, COGS is the amount of inventory actually
sold. Thus, when converting COGS, students must
consider both the change in accounts payable and
inventory. An example using T-accounts for inventory
Increase Decrease
Assets (prepaid expenses) +
deferral
Liabilities (payables) +
accrual
Revenue ($160,000 $5,200 + $6,900 + $1,300 $1,100) $161,900
Expenses ($97,000 + $1,400 $1,700 $2,800 + $4,400) 98,300
Net Income $63,600
Account Title January 1 December 1 Inc. (Dec.)
Accounts $5,200 $6,900 $1,700
Receivable
Unearned $1,300 $1,100 ($200)
Revenue
Accrued $2,800 $4,400 $1,600
Expenses
Prepaid $1,400 $1,700 $300
Expenses
Other Owners
Item Cash + Assets = Liabilities + Equity
Cash Basis Income $63,000 $63,000
Increase Accounts $1,700 1,700
Receivable
Decrease Unearned ($200) 200
Revenue
Increase Accrued $1,600 (1,600)
Expenses
Increase Prepaid $300 300
Expenses
Accrual Basis Income $63,600
38 MA N A G E ME N T A C C O U N T I N G Q U A R T E R L Y WI N T E R 2 0 1 3 , V O L . 1 4 , N O . 2
and accounts payable, therefore, could be used to show
the difference between cash payments for merchandise
purchases and COGS.
When converting from the cash basis income to
accrual basis income, depreciable assets are treated
essentially the same as prepaid expenses because
depreciable fixed assets represent long-term prepay-
ments (deferrals). Thus, the decrease in a fixed asset by
depreciation is treated the same as a decrease in pre-
paid expenses. Remind students that there is no depre-
ciation on a cash basis income statement because the
asset would have been an expense in the year pur-
chased. (See Table 6 for the second case facts.)
Table 6: Cash Flow of a Retail Store
During the year, the retail store collected $200,000 in
revenue, paid $120,000 to suppliers of inventory, and
paid $41,000 in other expenses. Depreciation of story
equipment totaled $5,000. Determine the following:
1. Cash basis operating income
2. Accrual basis sales
3. Accrual basis cost of goods sold
4. Accrual basis expenses
5. Accrual basis operating income
You can elaborate on the solutions in complete detail
after students have completed their work. For the purpose
of this article, however, the answers are provided without
details. The solution to question 1 is easy: ($200,000
$161,000 = $39,000). The answer to question 2 is $198,400;
question 3 is $120,600; question 4 is $46,400; and
question 5 is $31,400. Question 5 can be calculated in two
ways: first, by subtracting the answers to questions 3 and 4
from the answer to question 2: ($198,400 ($120,600 +
$46,400) = $31,400). Or students can start with the answer
to question 1 and add and subtract the account balances
(or changes in them), as was done in the first case. Recall
that there is a $5,000 decrease in a fixed asset in addition
to those changes reflected in the above table. (See Table
7a for the resulting accrual basis income statement.)
Table 7a: Accrual Basis Income Statement for a
Retail Store
Similar to the first case, the bottom-line answer could
be derived from using the first breakdown of the
accounting equation (see Table 7b).
Table 7b: Income Statement Using the Expanded
Accounting Equation
Account Title January 1 December 31 Inc. (Dec.)
Accounts $5,800 $4,000 ($1,800)
Receivable
Unearned $1,200 $1,000 ($200)
Revenue
Accrued $4,700 $4,600 ($100)
Expenses
Prepaid $1,600 $1,100 ($500)
Expenses
Accounts $6,500 $7,800 $1,300
Payable
(for inventory)
Merchandise $8,600 $9,300 $700
Inventory
Sales ($200,000 $5,800 + $4,000 + $1,200 $1,000) $198,400
Cost of Goods Sold (COGS)
($120,000 $6,500 + $7,800 + $8,600 $9,300) 120,600
Gross Profit $ 77,800
Operating Expenses (except depreciation)
($41,000 + $1,600 $1,100 $4,700 + $4,600) $41,400
Depreciation 5,000
46,400
Net Income $ 31,400
Other Owners
Item Cash + Assets = Liabilities + Equity
Cash Basis Income $39,000 $39,000
Decrease Accounts ($1,800) (1,800)
Receivable
Decrease Unearned ($200) 200
Revenue
Decrease Accrued ($100) 100
Expenses
Decrease Prepaid ($500) (500)
Expenses
Increase Accounts $1,300 (1,300)
Payable
Increase Merchandise $700 700
Inventory
Depreciation ($5,000) (5,000)
Accrual Basis Income $31,400
39 MA N A G E ME N T A C C O U N T I N G Q U A R T E R L Y WI N T E R 2 0 1 3 , V O L . 1 4 , N O . 2
STUDENT RESULTS
When using these cases in the classroom, I have seen
students develop an increased understanding of con-
verting the cash basis to the accrual basis and vice versa.
The focus on the differences between the two report-
ing methods helped their understanding as well. These
topics are relevant and helpful for students working on
problems associated with determining cash provided by
operations on the Statement of Cash Flows; the addi-
tions and subtractions involved with reconciling the
accrual basis net income with cash provided, however,
are the opposite of the illustrations in this article. I
Neal VanZante, Ph.D., CMA, CFM, CFE, is also a licensed
CPA in Oklahoma, Colorado, and Texas. He is a member of
IMAs San Antonio Chapter and can be contacted at
(361) 944-8274 or nealvz@stx.rr.com.
Reproduced with permission of the copyright owner. Further reproduction prohibited without
permission.