- A bookkeeper using accrual accounting mistakenly recorded a $50,000 cash payment received in advance from a customer as Service Revenue. The service will not be performed until the next fiscal year. The error is discovered before the financial statements are issued. Which of the following describes the net effect of the entry required to correct this error?
Answer: Total liabilities will increase by $50,000, and stockholders' equity will decrease by $50,000.
The incorrect entry was Debit Cash $50,000 and Credit Service Revenue $50,000. The correct entry should have been Debit Cash $50,000 and Credit Unearned Revenue $50,000.
To correct this error, the bookkeeper must reverse the revenue and recognize the liability. The correcting entry is:
Debit Service Revenue $50,000
Credit Unearned Revenue $50,000
This correcting entry has the following effects:
1. Decreases Service Revenue by $50,000, which reduces net income and thus stockholders' equity by $50,000.
2. Increases the liability account Unearned Revenue by $50,000.
There is no effect on total assets.
- Zenith Corp. is a management consulting firm that bills clients upon completion of projects, often several months after work begins. Apex Retail is a grocery store chain with nearly all sales in cash. Both companies are experiencing similar, steady growth in business volume. Which statement most accurately compares the likely relationship between net income (NI) and cash flow from operations (CFO) for the two firms?
Answer: For Zenith, NI will likely be significantly higher than CFO; for Apex, NI and CFO will be reasonably close.
For Zenith, a growing service firm with credit terms, growth means Accounts Receivable will constantly increase. This is because revenue is recognized as it's earned, but cash collection lags. A growing A/R balance means accrual net income will be significantly and persistently higher than cash flow from operations. For Apex, a cash-based retailer, revenue recognition is nearly simultaneous with cash collection. While differences between NI and CFO will exist due to changes in inventory, payables, and non-cash expenses like depreciation, the primary driver of large discrepancies (accounts receivable) is absent. Thus, its NI and CFO will be much more closely aligned than Zenith's.
- On January 1, Year 1, a company purchased equipment for $200,000 cash. The equipment has a 5-year useful life and no salvage value, and the company uses straight-line depreciation. What is the difference between the total expense recognized for this equipment over Year 1 and Year 2 combined under the cash basis versus the accrual basis?
Answer: The cash basis recognizes $120,000 more expense.
First, calculate the total expense under each method for the two-year period (Year 1 + Year 2).
Cash Basis:
The entire cash outflow is expensed at the time of purchase.
- Expense in Year 1 = $200,000
- Expense in Year 2 = $0
- Total Cash-Basis Expense = $200,000
Accrual Basis:
The cost is allocated over the asset's useful life as depreciation expense.
- Annual Depreciation = ($200,000 − $0) / 5 years = $40,000
- Expense in Year 1 = $40,000
- Expense in Year 2 = $40,000
- Total Accrual-Basis Expense = $80,000
Difference:
Difference = Total Cash-Basis Expense − Total Accrual-Basis Expense
Difference = $200,000 − $80,000 = $120,000
The cash basis recognizes $120,000 more expense over the first two years.
- During the year, a retail company paid $300,000 cash to its suppliers. The company's Inventory balance increased by $40,000, and its Accounts Payable balance decreased by $15,000 over the year. What is the company's Cost of Goods Sold for the year under the accrual basis?
Answer: $245,000
This is a two-step problem. First, convert cash paid to suppliers to purchases. Second, use purchases and the change in inventory to calculate Cost of Goods Sold (COGS).
Step 1: Calculate Purchases.
Purchases = Cash Paid to Suppliers − Decrease in Accounts Payable
Purchases = $300,000 − $15,000 = $285,000
(A decrease in A/P means cash paid was more than current period's purchases, so purchases are lower than cash paid.)
Step 2: Calculate Cost of Goods Sold.
COGS = Purchases − Increase in Inventory
COGS = $285,000 − $40,000 = $245,000
(An increase in inventory means not all purchases were sold, so COGS is lower than purchases.)
- On November 1, Year 1, a company paid $24,000 for a one-year advertising contract that began on that date. The company's fiscal year ends on December 31. For Year 1, how much more advertising expense will be recognized under the cash basis than under the accrual basis?
Answer: $20,000
First, calculate the advertising expense for Year 1 under each accounting method.
Cash Basis:
The entire cash payment is recognized as an expense in the period it was paid.
- Cash-Basis Expense in Year 1 = $24,000
Accrual Basis:
The cost is allocated over the period the service is received.
- Monthly Expense = $24,000 / 12 months = $2,000
- In Year 1, the company receives the service for 2 months (November and December).
- Accrual-Basis Expense in Year 1 = $2,000/month × 2 months = $4,000
Difference:
Difference = Cash-Basis Expense − Accrual-Basis Expense
Difference = $24,000 − $4,000 = $20,000
- What amounts should be reported in Medical Associates' December 2023 financial statements under each accounting method?
Answer: Accrual accounting: $12,000 revenue, $15,000 liability; Cash accounting: $15,000 revenue, no liability recorded
Under accrual accounting, only the $12,000 of services performed in December is recognized as revenue, with the $15,000 prepayment recorded as unearned revenue (liability). Under cash accounting, the $15,000 received is recorded as revenue with no liability recognition since cash accounting doesn't typically record unearned revenue. Choice B incorrectly includes both amounts as accrual revenue. Choice C reverses the accounting methods. Choice D incorrectly shows a liability under cash accounting.
- Use the following selected year-end data for a company to answer the question:
Cash collected from customers: $250,000
Cash paid for operating expenses: $140,000
Increase in accounts receivable during the year: $30,000
Increase in wages payable during the year: $10,000
Based on the data provided, what is the company's accrual-basis net income for the year?
Answer: $130,000
To calculate accrual-basis net income, we must first determine accrual-basis revenues and accrual-basis expenses.
1. Calculate Accrual Revenue:
Accrual Revenue = Cash Collected from Customers + Increase in Accounts Receivable
Accrual Revenue = $250,000 + $30,000 = $280,000
2. Calculate Accrual Operating Expenses:
Accrual Operating Expenses = Cash Paid for Operating Expenses + Increase in Wages Payable
Accrual Operating Expenses = $140,000 + $10,000 = $150,000
3. Calculate Accrual-Basis Net Income:
Accrual Net Income = Accrual Revenue − Accrual Operating Expenses
Accrual Net Income = $280,000 − $150,000 = $130,000
- On April 1, Year 1, a software company receives $60,000 cash from a client for a 2-year service contract. The company has a December 31 year-end. Under the accrual basis of accounting, how much revenue from this contract should the company recognize in Year 1?
Answer: $22,500
Under accrual accounting, revenue is recognized as it is earned, not when cash is received. The $60,000 payment covers a 24-month period. The monthly revenue is $60,000 / 24 months = $2,500.
In Year 1, the service is provided from April 1 to December 31, which is a period of 9 months.
The revenue to be recognized in Year 1 is: $2,500/month × 9 months = $22,500.
- On July 1, Year 1, a company paid a $36,000 premium for a 24-month insurance policy. The company's fiscal year ends on December 31. What is the total insurance expense the company will recognize for this policy in Year 2 under the accrual basis and cash basis, respectively?
Answer: Accrual: $18,000; Cash: $0
Under the cash basis, the entire $36,000 cash payment is recognized as an expense in the period it was paid, which is Year 1. Therefore, the cash-basis expense for Year 2 is $0.
Under the accrual basis, the cost of the insurance policy is allocated systematically over the 24-month period it covers. The monthly expense is $36,000 / 24 months = $1,500. Year 2 covers a full 12 months (from January 1 to December 31). Therefore, the accrual-basis insurance expense for Year 2 is 12 months * $1,500/month = $18,000.
- A new, rapidly growing technology firm makes all of its sales on credit. The firm is considering switching from cash-basis to accrual-basis accounting for its internal management reports. Which of the following describes the most likely immediate impact of this change on the firm's working capital (Current Assets − Current Liabilities)?
Answer: Working capital will increase, because the recognition of Accounts Receivable will exceed the recognition of Accounts Payable.
Switching from cash to accrual basis will cause the firm to recognize current assets like Accounts Receivable and current liabilities like Accounts Payable. For a rapidly growing firm whose sales are all on credit, Accounts Receivable will likely be substantial and growing quickly. While Accounts Payable will also be recognized, the growth in receivables (tied to revenue) is often much larger than the growth in payables for a profitable, expanding company. Therefore, the increase in Current Assets (from A/R) is likely to be greater than the increase in Current Liabilities (from A/P), leading to an increase in working capital.
- Comparing the cash and accrual bases of accounting, which statement is true regarding the total net income reported over the entire life of a business, from its inception to its final liquidation?
Answer: Accrual-basis and cash-basis net income will be equal, as all timing differences reverse over the long run.
Over the entire life of a business, all revenues will eventually be collected in cash, and all expenses will eventually be paid in cash. Accrual accounting and cash accounting simply recognize these events in different time periods. By the time a company liquidates, all accounts receivable have been collected or written off, all payables have been paid, and all prepayments have been expensed. Therefore, the total net income over the company's life will be the same under both methods, equalling total lifetime cash inflows minus total lifetime cash outflows.
- The compensation plan for a division manager includes a significant bonus based on the division's 'net cash flow from operations' for the fiscal year. To maximize her bonus for the current year, which of the following actions is the manager most likely to pursue in the final weeks of the year?
Answer: Delay payments on outstanding invoices to suppliers until the beginning of the next fiscal year.
The manager's bonus is based on net cash flow, which is cash inflows minus cash outflows. To maximize this figure, the manager is incentivized to accelerate cash inflows and/or delay cash outflows. Delaying payments to suppliers (Choice B) directly reduces cash outflows for the current period, thus increasing the net cash flow and the manager's bonus. Offering extended payment terms (Choice A) would delay cash inflows. Purchasing equipment (Choice C) is a large cash outflow for investing, not operations, but still reduces cash. A non-cash charge (Choice D) affects accrual net income but has no immediate impact on cash flow.
- What is the 2023 net income under accrual accounting, and how does it compare to the net cash flow from operations?
Answer: Net income: $60,000; exceeds cash flow by $5,000 due to working capital changes
This question tests your understanding of accrual accounting versus cash accounting and how timing differences affect financial reporting. When comparing net income to operating cash flow, you need to carefully track what's recognized versus what's actually received or paid.
Under accrual accounting, you recognize revenue when earned and expenses when incurred, regardless of cash timing. For 2023 net income: Revenue is $180,000 (services performed), and expenses are $120,000 (costs incurred), giving net income of $60,000.
For operating cash flow, you track actual cash movements: collected $150,000 from clients, paid $110,000 in expenses, and received $25,000 in advance payments (which represents cash inflow from operations, even though it's unearned revenue). Total operating cash flow is $150,000 - $110,000 + $25,000 = $65,000.
Net income ($60,000) exceeds cash flow ($65,000) by $5,000 because of working capital changes.
Answer A incorrectly calculates net income as $65,000 and wrongly assumes advance payments offset receivables. Answer B correctly identifies net income as $60,000 but miscalculates the cash flow difference as $35,000 instead of $5,000. Answer C incorrectly states net income as $65,000 and claims cash flow exceeds net income by $30,000, which reverses the actual relationship.
Remember: when comparing accrual net income to operating cash flow, always separate what was earned/incurred (for income statement) from what was actually received/paid (for cash flow). Advance payments create cash inflows even though they're liabilities, not revenue.
- A company reported accrual-basis revenue of $850,000 for the year. The beginning and ending balances of its Accounts Receivable were $70,000 and $95,000, respectively. What was the total amount of cash collected from customers during the year?
Answer: $825,000
To find the cash collected from customers, we can analyze the changes in the Accounts Receivable T-account. The formula is:
Cash Collections = Beginning A/R + Accrual Revenue − Ending A/R.
Plugging in the given values:
Cash Collections = $70,000 + $850,000 − $95,000 = $825,000.
An increase in Accounts Receivable of $25,000 ($95,000 - $70,000) means that the company recognized $25,000 more in revenue than it collected in cash. Therefore, cash collections are $25,000 less than accrual revenue.
- A law firm began the year with $50,000 in its Unearned Retainer Fees account. During the year, the firm collected $400,000 in cash from clients as retainers. At the end of the year, the Unearned Retainer Fees account had a balance of $35,000. What was the amount of legal service revenue recognized by the firm for the year under the accrual basis?
Answer: $415,000
The Unearned Retainer Fees account is a liability that represents cash received from clients before legal services are provided. Revenue is recognized when the services are actually performed. We can determine the revenue recognized by analyzing the change in the Unearned Retainer Fees account.
The formula is:
Accrual Revenue = Beginning Unearned Revenue + Cash Received − Ending Unearned Revenue
Plugging in the given values:
Accrual Revenue = $50,000 + $400,000 − $35,000 = $415,000.
- A primary reason that accrual accounting provides a more faithful representation of a company's periodic performance than cash-basis accounting is that accrual accounting:
Answer: matches the costs of generating revenues to the same period the revenues are recognized.
The core of accrual accounting is the matching principle, which dictates that expenses incurred to generate revenue should be recognized in the same period as the revenue itself. This creates a cause-and-effect relationship between revenues and expenses, providing a more accurate picture of a company's profitability for a given period. Choice A is incorrect; over the life of a company, total income is the same under both methods. Choice B is incorrect; accrual accounting is often more subjective (e.g., estimates for bad debts, depreciation), while cash basis is tied to objective cash movements. Choice D is incorrect; while many businesses use accrual for tax, it's not universally required, and the conceptual reason for its superiority is independent of tax rules.
- For the year, a company reported $720,000 in accrual-basis revenue. Its cash-basis revenue (i.e., cash collections from customers) for the same period was $680,000. If the Accounts Receivable balance at the beginning of the year was $110,000, what was the Accounts Receivable balance at the end of the year?
Answer: $150,000
The difference between accrual-basis revenue and cash collections from customers represents the net change in the Accounts Receivable balance for the period.
Change in A/R = Accrual Revenue − Cash Collections
Change in A/R = $720,000 − $680,000 = $40,000 increase
To find the ending balance, add the increase to the beginning balance:
Ending A/R = Beginning A/R + Change in A/R
Ending A/R = $110,000 + $40,000 = $150,000.
- A new consulting firm had the following transactions in its first month:
1. Provided services worth $25,000 on credit.
2. Collected $10,000 cash from the credit services provided above.
3. Paid $8,000 in cash for salaries earned and paid in the month.
4. Incurred $4,000 of administrative expenses on credit, to be paid next month.
What is the difference between the firm's accrual-basis net income and its cash-basis net income for the month?
Answer: Accrual basis is $11,000 higher.
First, calculate net income under both methods.
Accrual-Basis Net Income:
Revenue is recognized when earned, and expenses are recognized when incurred.
- Revenue: $25,000 (services provided)
- Expenses: $8,000 (salaries) + $4,000 (admin) = $12,000
- Accrual NI = $25,000 − $12,000 = $13,000
Cash-Basis Net Income:
Revenue is recognized when cash is received, and expenses are recognized when cash is paid.
- Revenue: $10,000 (cash collected)
- Expenses: $8,000 (cash paid)
- Cash NI = $10,000 − $8,000 = $2,000
Difference:
Difference = Accrual NI − Cash NI = $13,000 − $2,000 = $11,000.
Accrual basis net income is $11,000 higher than cash basis net income.
- What amount should Milestone Construction report as revenue for the year ended December 31, 2023, under accrual accounting versus cash accounting?
Answer: Accrual: $96,000; Cash: $120,000
Under accrual accounting, revenue is recognized based on performance (40% × $240,000 = $96,000). Under cash accounting, revenue equals cash received ($120,000). Choice B reverses the amounts. Choice C uses costs incurred rather than percentage complete for accrual. Choice D recognizes the full contract value under accrual before completion.
- A company's cash-basis net income for the year was $200,000. Its Accounts Receivable increased by $25,000 during the year, while its Accounts Payable decreased by $10,000. Assuming these are the only relevant adjustments, what was the company's accrual-basis net income?
Answer: $215,000
To convert from cash-basis to accrual-basis net income, we adjust for changes in operating assets and liabilities using the formula:
Accrual NI = Cash NI + Increase in A/R - Decrease in A/P
Calculation:
- Start with cash-basis net income: $200,000
- Add increase in A/R: $25,000 (represents revenue earned but not yet collected)
- Subtract decrease in A/P: $10,000 (represents additional cash paid beyond current period expenses)
Accrual NI = $200,000 + $25,000 - $10,000 = $215,000
