Accrual Accounting and Income Determination - Pearson Learning ...

84 CHAPTER 2 Accrual Accounting and Income DeterminationAs shown, two adjustments are required to convert accrual-basis cost of goods sold ($2,100,000)to cash-basis expense for inventory purchases ($2,900,000). The first adjustment for the inventoryincrease is because beginning inventory is a non-cash addition to cost of goods sold, while endinginventory is a non-cash deduction in arriving at cost of goods sold (see cost of goods sold schedule onpage 83). Therefore, to remove the net non-cash effects of beginning and ending inventory from costof goods sold, we must add the increase in inventory. (If inventory had declined, we would subtract thedecrease.) Making this adjustment to cost of goods sold gives us the total inventory purchased in 2005.(We’ve assumed that all inventory purchases are on account. Consequently, all inventory purchasesduring the year would be credited to Accounts payable.)The second adjustment—for the decrease in Accounts payable—is because Trevian’s cashpayments for inventory purchased on account exceeded new inventory purchases on account in thecurrent period (see Accounts payable schedule on page 83). Thus, Trevian’s cash payments for inventoryactually exceeded the credit purchases of inventory that’s included in the accrual-basis cost ofgoods sold number. Accordingly, to convert the accrual-basis cost of goods sold expense to a cash-basisexpense, the decrease in accounts payable must be added. (If Accounts payable had increased, thischange would have been subtracted.)Note that in the previous discussion the adjustments made are to convert accrual-basis expense tocash-basis expense. To adjust accrual-basis income to obtain cash-basis income (cash flow from operations),the adjustment for the changes in Inventory and Accounts payable would be in the oppositedirection. That is, the increase in Inventory and the decrease in Accounts payable would be subtractedfrom accrual income to obtain cash flow from operations. This is because adjustments to expense havethe opposite effect on income.In general, analyses similar to that used for Accounts receivable and Accounts payable can be carriedout for Accrued revenue, Accrued expense, Deferred (unearned) revenue, and Deferred (prepaid)expense accounts to deduce other differences between accrual-basis income and cash-basis income.Understanding that differences between accrual-basis and cash-basis income can be gleaned frommost working capital accounts (that is, current asset and current liability accounts reported on the balancesheet) is one of the key lessons in financial statement analysis that we will return to repeatedlythroughout later chapters in this book.EXERCISESNOT AVAILABLE FORELECTRONIC VIEWINGISBN: 0-536-06624-8Financial Reporting and Analysis, Third Edition, by Lawrence Revsine, Daniel W. Collins, and W. Bruce Johnson.Copyright © 2005 by Pearson Education, Inc. Published by Prentice Hall.