Using the Basic
Accounting Equation
to Help Students
Understand Differences
Between the Cash Basis
and Accrual Basis
B Y N E A L VA N Z A N T E , P H . D . , C M A , C F M , C PA , C F E
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.
any small businesses and nonprofit
organizations maintain their accounting
records on a cash basis. Yet generalpurpose financial statements must be
reported using the accrual basis,
requiring accountants to convert the records. Thus it is
important that accounting students understand the differences 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 student’s career, he or she is
still getting accustomed to the basic accounting equation 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 presentations, 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
M
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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 inventories 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).
each type of cash increase and decrease during class discussion. Use an example of a cash basis income statement
and balance sheet to show that cash receipts are considered revenues and that cash payments are considered
expenses. The resulting balance sheet consists of two
items: cash on the left and owner’s equity on the right. In
other words, there are no other assets or liabilities associated 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
E X PA N S I O N O F T H E B A S I C
basis,
revenue is recognized when cash is collected from
A C C O U N T I N G E Q UAT I O N
customers and expenses are recognized when they are
Before discussing conversion of cash basis financial
paid; under the accrual basis, however, revenue is recstatements, review the basics of the accounting equaognized when it is earned and expenses are recognized
tion that involve increases and decreases in total assets
as they are incurred. Remind students that Generally
(see Table 1a).
Accepted Accounting Principles (GAAP) require the
accrual
basis because of the revenue and expense
Table 1a: Basic Accounting Equation
recognition principles.
Assets
=
Liabilities + Owner’s Equity
Because revenues can be collected before or after
Asset Increases:
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
Asset Decreases:
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 represented
by amounts in accounts such as prepaid
After discussing increases and decreases, expand the
expenses (payment before expenses are incurred) and
equation by splitting the Assets side of the equation
various accrued or payable accounts (payment after
into Cash and Other Assets (see Table 1b).
expenses are incurred).
At this point, you can return to Tables 1a and 1b to
Table 1b: Expanded Accounting Equation
demonstrate how changes in other assets and
Cash +
Other Assets = Liabilities + Owner’s Equity
liabilities influence the cash basis income and
Cash Inflows:
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
Cash Outflows:
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
Table 1b provides a clear picture of how cash inflows
to clarify differences as well.
and outflows affect other accounts. Present examples of
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FURTHER BREAKDOWN
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).
OF THE
A C C O U N T I N G E Q UAT I O N
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 differences. Before moving on, make sure that students
understand how changes in other assets and liabilities
impact the conversion and how the effect of the beginning 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 balances 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 conversion as well (ending balance subtracted and beginning balance added). Because accounts receivable is
an asset and unearned revenue is a liability, these balances should be treated differently. This leads to a
further breakdown of the basic accounting equation
(see Table 2a).
Table 2b: Converting from Cash
to Accrual Operating Income
Beginning
Ending
–
+
Liabilities (payables,
unearned revenues)
+
–
–
Liabilities (payables,
unearned revenues)
–
+
Table 3a: Converting Cash Basis Revenues
to Accrual Basis Revenues
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
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Decrease
+
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 section 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 revenues 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 discussions, I sometimes present additional matrices (one for
revenues, Table 3a, and one for expenses, Table 3b).
Table 2a: Converting from Cash
to Accrual Operating Income
Assets (receivables,
prepaid expenses)
Increase
Assets (receivables,
prepaid expenses)
36
Increase
Decrease
Assets (receivables)—
accrual
+
–
Liabilities (unearned
revenues)—deferral
–
+
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Table 3b: Converting Cash Basis Expenses
to Accrual Basis Expenses
Increase
Decrease
Assets (prepaid expenses)—
deferral
–
+
Liabilities (payables)—
accrual
+
–
$63,600. (See Table 5a for the resulting accrual basis
income statement.)
Table 5a: Accrual Basis Income Statement
Revenue ($160,000 – $5,200 + $6,900 + $1,300 – $1,100) $161,900
Expenses ($97,000 + $1,400 – $1,700 – $2,800 + $4,400)
Net Income
98,300
$63,600
The calculations of revenues and expenses in
Table 5a use the beginning and ending account balances, 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).
THE FIRST 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
Account Title
January 1
December 1
Inc. (Dec.)
Accounts
Receivable
$5,200
$6,900
$1,700
Unearned
Revenue
$1,300
$1,100
($200)
Accrued
Expenses
$2,800
$4,400
$1,600
Prepaid
Expenses
$1,400
$1,700
$300
Table 5b: Income Statement Using the Expanded
Accounting Equation
Item
Cash
+
Other
Owner’s
Assets = Liabilities + Equity
Cash Basis Income $63,000
Increase Accounts
Receivable
$1,700
Decrease Unearned
Revenue
Increase Prepaid
Expenses
1,700
($200)
Increase Accrued
Expenses
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
$1,600
$300
Accrual Basis Income
THE SECOND CASE
Before the second case is assigned (after discussion of
inventories), return to the expanded equations and consider 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
Elaborate on the solutions after students have completed 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 subtracting account balances (or changes in them) to the
cash basis operating income. The answer would still be
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200
(1,600)
300
$63,600
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 prepayments (deferrals). Thus, the decrease in a fixed asset by
depreciation is treated the same as a decrease in prepaid expenses. Remind students that there is no depreciation on a cash basis income statement because the
asset would have been an expense in the year purchased. (See Table 6 for the second case facts.)
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
Sales ($200,000 – $5,800 + $4,000 + $1,200 – $1,000)
Table 6: Cash Flow of a Retail Store
$198,400
Cost of Goods Sold (COGS)
($120,000 – $6,500 + $7,800 + $8,600 – $9,300)
Account Title
January 1
December 31 Inc. (Dec.)
Accounts
Receivable
$5,800
$4,000
($1,800)
Unearned
Revenue
$1,200
$1,000
($200)
Accrued
Expenses
$4,700
$4,600
($100)
Prepaid
Expenses
$1,600
$1,100
($500)
Accounts
Payable
(for inventory)
$6,500
$7,800
$1,300
Merchandise
Inventory
$8,600
$9,300
$700
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
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
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
Item
Cash
+
Other
Owner’s
Assets = Liabilities + Equity
Cash Basis Income $39,000
Decrease Accounts
Receivable
$39,000
($1,800)
($200)
200
Decrease Accrued
Expenses
($100)
100
($500)
Increase Accounts
Payable
Increase Merchandise
Inventory
Depreciation
Accrual Basis Income
38
(1,800)
Decrease Unearned
Revenue
Decrease Prepaid
Expenses
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 $46,400; and
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$ 31,400
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(500)
$1,300
$700
($5,000)
(1,300)
700
(5,000)
$31,400
S T U D E N T R E S U LT S
When using these cases in the classroom, I have seen
students develop an increased understanding of converting the cash basis to the accrual basis and vice versa.
The focus on the differences between the two reporting 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 additions and subtractions involved with reconciling the
accrual basis net income with cash provided, however,
are the opposite of the illustrations in this article. ■
Neal VanZante, Ph.D., CMA, CFM, CFE, is also a licensed
CPA in Oklahoma, Colorado, and Texas. He is a member of
IMA’s San Antonio Chapter and can be contacted at
(361) 944-8274 or [email protected].
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