Companies required to comply with GAAP maintain their accounting records on the accrual basis for financial accounting and reporting purposes. GAAP stands for generally accepted accounting standards, and companies that are publicly traded or circulate their financial statements for the purpose of raising money are required to follow GAAP. For income tax purposes, however, companies need to measure income on the cash basis of accounting. Converting from accrual basis to cash basis is necessary to determine the current income tax payments due at any given time. Cash basis accounting is also known as the income tax basis of accounting.
- Skill level:
- Moderately Challenging
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Gain an understanding of the difference between accrual accounting and cash basis accounting. The accrual method recognises income when it is earned (accounts receivable) and expenses when they are incurred (accounts payable). The cash method recognises income when cash is received and expenses when cash is paid.
Identify the accounts that will need to be adjusted (any balance sheet accounts with non cash transactions) and analyse the changes to account balances during the year. An increase in current assets is subtracted from net income; a decrease in current assets is added to net income. An increase in current liabilities is added to net income; a decrease in current liabilities is subtracted from net income.
Determine the amount of the adjustment. The amount of the adjustment depends on the change to non cash account balances during the year. For example, the adjustment to accounts receivable would be; beginning balance + accrual -- ending balance = cash receipts during the year (this formula is the same for all current assets). The adjustment for salaries payable would be beginning balance + accrual -- ending balance = cash payments during the year (this formula is the same for all current liabilities).
Make the necessary adjustments. There are two methods for making the necessary adjustments the direct method and the indirect method. The direct method involves adjustments directly to the accounts affected. The indirect method involves adjustments to net income. The results are the same either way.
Create the cash basis financial statements. When creating cash basis financial statements you will need to show the accounts, so it is better to use the direct method. This way, you will have the correct balance in each account for the financial statements. The indirect method can be used if you are not presenting cash basis financial statements but simply want to know the cash basis income.
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