In Its First Year Of Operations, Grace Company Reports The Following: Earned Revenues Of $60,000 ($52,000 Cash Received From Customers); Incurred Expenses Of $35,000 ($31,000 Cash Paid Toward Them); Prepaid $8,000 Cash For Costs That Will Not Be Expensed Until Next Year. Net Income Under The Cash Basis And Accrual Basis Of Accounting Is:
Net Income Under Cash Basis vs. Accrual Basis of Accounting (Solved Example)
Understanding the difference between the cash basis and accrual basis of accounting is essential for accounting students, business owners, and anyone preparing for accounting exams. While both methods measure business performance, they recognize revenue and expenses at different times, resulting in different net income figures.
Let's solve this accounting problem step by step.
Problem
In its first year of operations, Grace Company reports the following:
Earned revenues of $60,000, of which $52,000 was received in cash from customers.
Incurred expenses of $35,000, of which $31,000 was paid in cash.
Prepaid $8,000 in cash for costs that will not be recognized as expenses until next year.
Question: What is Grace Company's net income under the cash basis and accrual basis of accounting?
Step 1: Net Income Under the Cash Basis of Accounting
The cash basis of accounting records revenue only when cash is received and expenses only when cash is paid.
Cash Received
Revenue collected in cash: $52,000
Cash Paid
Expenses paid in cash: $31,000
Calculation
Net Income = Cash Revenue − Cash Expenses
Net Income = $52,000 − $31,000 = $21,000
Answer (Cash Basis): B) $21,000
Step 2: Net Income Under the Accrual Basis of Accounting
The accrual basis of accounting recognizes revenue when it is earned and expenses when they are incurred, regardless of when cash is received or paid.
Revenue Earned
Total earned revenue: $60,000
Expenses Incurred
Total incurred expenses: $35,000
The $8,000 prepaid amount should not be added to current-year expenses because it represents a future benefit and will be recognized as an expense in the next accounting period. Therefore, it remains an asset at year-end.
Calculation
Net Income = Earned Revenue − Incurred Expenses
Net Income = $60,000 − $35,000 = $25,000
Answer (Accrual Basis): D) $25,000
Final Answer
| Accounting Method | Net Income |
|---|---|
| Cash Basis | $21,000 |
| Accrual Basis | $25,000 |
Why Are the Results Different?
The difference arises because each accounting method recognizes transactions differently.
Cash Basis
Records only cash received and cash paid.
Simple to maintain.
Often used by small businesses and individuals.
Accrual Basis
Records revenue when it is earned and expenses when they are incurred.
Matches income with related expenses.
Provides a more accurate picture of a company's financial performance.
Required by many businesses under generally accepted accounting principles (GAAP).
In this example, the accrual basis reports higher net income ($25,000) because Grace Company earned revenue that has not yet been collected in cash, while the prepaid $8,000 is not yet an expense and therefore should not reduce current-year income.
Key Takeaway
When solving accounting problems, always identify whether the question requires the cash basis or the accrual basis of accounting.
Under the cash basis, use only cash received and cash paid.
Under the accrual basis, use revenue earned and expenses incurred, and remember that prepaid expenses are assets until they are actually used or expire.
Correct Answers:
Cash Basis Net Income: B) $21,000
Accrual Basis Net Income: D) $25,000
Comments