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CFA Level 1 - Cash Vs. Accrual Accounting A. ACCRUAL ACCOUNTING
Within this section, we will review cash vs. accrual accounting methodologies. Note that the material set forth in this section is intended as a review and CFA Institute will most likely not ask a question directly based on this material. However, we recommend a read of this section is you are unfamiliar with accounting as you will need this knowledge in order to succeed in future sections.
I. Cash vs. Accrual Accounting
Within this section we will explain how income measurement issues are resolved, accrual accounting, and why the accrual basis of accounting produces more useful income statements and balance sheets than the cash basis.
Benefits of Cash Accounting
Benefits
- It is easy to use and implement because the company records income only when it gets paid and records expenses only when it pays them.
- If accepted by the IRS (limited cases only), the company is taxed when it has money in the bank.
- On average, fewer transactions will be recorded (bookkeeping).
Biggest Drawback
- Cash accounting can distort a company's actual income and expenses, especially if it extends credit to its customers, purchases raw materials on credit from its suppliers or keeps inventory.
Benefits of Accrual Accounting
- Generally, it provides a clearer picture of the financial performance (income statement) and financial health (balance sheet).
- It allows management to keep track of accounts receivables and payables more efficiently.
- It is more representative of the economic reality of the business. A service provider may not require upfront payment for an annual service; this revenue will be recorded as it is performed, not when it is paid. Similarly, expenses that are paid in advance - such as property taxes, which are paid semiannually - will be recognized on a monthly basis.
- It enhances comparability of performance (income statement) and financial stability (balance sheet) from one period to the next.
- There is a smoother earning stream.
- There is enhanced predictability of future cash flow.
Let's consider a practical example to fully understand the impact of Cash versus Accrual Accounting on XYZ Corporation's Income Statement and Balance Sheet.
Cash Basis Accounting
Taken as is, the financial statements in Figure 6.1 below indicate that XYZ Corporation is not doing well, with a net loss of $43,200, and may not be a good investment opportunity.
Figure 6.1: XYZ Corporation's Financial Statements using Cash Basis Accounting
Note: For simplicity the tax effect not considered.
Accrual Basis Accounting
Armed with some additional information, let's see what the income statement would look like if the accrual-basis accounting method was used.
Additional Information:
A1. June 12, 2005 – The company received a rush order for $80,000 of wood panels. The order was delivered to the customer five days later. The customer was given 30 days to pay. (With the cash-basis method, sales are not recorded in the income statement and not recorded in accounts receivables: no cash, no record).
A2. June 13, 2003 – The company received $60,000 worth of wood panels to replenish their inventory, and $40,000 was related to the rush order. The company paid the invoice in full to take advantage of a 2% early-payment discount. (With the cash-basis method, this is recorded in full on the income statement, and there is no record of inventory on hand).
A3. June 1, 2005 – The company launched an advertising campaign that will run until the end of August. The total cost of the advertising campaign was $15,000 and was paid on June 1, 2005.
Figure 6.2: XYZ Corporation's Restated Financial Statements using Accrual Basis Accounting
Note: tax effect not considered
Adjustments:
To obtain the figures in the restated financial statements in figure 6.2 above, the following adjusting entries were made:
A1. Product sales and Accounts receivable – Even though the client has not paid this invoice, the company still made a sale and delivered the products. As a result, sales for the accounting period should increase by $80,000. Account s receivables (reported sales made but awaiting payment) should also increase by $80,000.
Adjusting entries:
A2. June 13, 2003 – Since the entire $60,000 order was paid during the accounting period, the full amount was included in production costs under the cash-basis method. Only $40,000 of the order was related to product sales during that accounting period, and the rest was stored as inventory for future product sales.
Adjusting entries:
A3. June 1, 2005 – Marketing expenses included in the income statement totaled $15,000 for a three-month advertising campaign because it was paid in full at initiation (cash-basis accounting). The reality is that this campaign will last for three months and will generate a benefit for the company every month. As a result, under accrual-basis accounting, the company should record in this accounting period only one-third of the cost. The remainder should be allocated to the next period and recoded as prepaid expenses on the assets side of the balance sheet.
Adjusting entries:
Results:
Under cash-basis accounting, this company was not profitable and its balance sheet would have been weak at best. Under accrual accounting, the financials tell us a very different story.
Debit:An accounting term that refers to an entry that increases an expense or asset account, or decreases an income, liability or net-worth account.
Credit: An accounting term that refers to an entry that decreases an expense or asset account, or increases an income, liability or net-worth account.
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Going forward, all statements will use accrual-basis accounting. Please note that on the exam, candidates should assume that all financial statements use accrual-basis accounting, unless it is specified that the cash-basis accounting method is used in the question.
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Next: CFA Level 1 - Income Statement Basics |
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