Using the Basic Accounting Equation to Help Students Understand Differences between the Cash Basis and Accrual Basis

Many 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 to the accrual basis. The first case is based on a service organization with no fixed assets; therefore, it focuses on 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). EXPANSION OF THE BASIC ACCOUNTING EQUATION Before discussing conversion of cash basis financial statements, review the basics of the accounting equation that involve increases and decreases in total assets (see Table 1a). 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 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 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 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 recognized 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 represented by amounts in accounts such as prepaid expenses (payment before expenses are incurred) and various accrued or payable accounts (payment after expenses are incurred). …