Question

During 2018, HomeVideo, Inc. recorded all cash receipts and cash disbursements. However, HomeVideo, Inc.’s banker is requiring an income statement and balance sheet prepared on an accrual basis.

The following is a recap of the cash receipts for 2018:

Collections from customers	$      356,800
Proceeds from bank loan	75,000
Proceeds from sale of common stock	100,000
	$      531,800

The cash disbursements data is available on the attached Excel sheet. In addition, HomeVideo, Inc.’s payroll disbursements for wages totaled $105,200. The data was obtained from a separate (not provided) payroll journal.

Daniels’, a family friend, has asked for your assistance in preparing HomeVideo, Inc.’s financial statements at December 31, 2018 on an accrual basis. The following additional information is available:

1. Customers owed the company $16,500 at year-end for credit sales. Also, HomeVideo, Inc.’s cash collections included $7,000 of amounts collected in advance from other customers for services to be performed in 2019.
2. The firm signed a 3-year lease for a retail store with rent payments starting in January 2018. The rent is due on the 15^thof every month. Additionally, a security deposit of $5,000 was paid along with the first rent payment. This deposit is likely to be returned at the end of the lease term.
3. The equipment purchased during 2018 is depreciated on a straight-line basis assuming no salvage value. The firm uses a convention where one-half year of depreciation is taken in the year of acquisition (regardless of the actual purchase date).
4. The insurance payment was for a 1-year policy starting on February 1, 2018.
5. At year-end, $21,000 is owed to suppliers for merchandise purchased on credit and received.
6. At year-end, merchandise inventory costing $53,700 and supplies totaling $6,400 remained on hand.
7. Salaries earned, but not yet paid to employees at year-end totaled $7,300.
8. The bank loan requires interest at 10% per year and was issued on June 1, 2018. The principal and interest are to be repaid together on May 31, 2019.

Home Video, Inc. (Cash disbursements 1/1/2018 through 3/31/2019):

Insurance (2/1/18)

28,000

Merchandise (2018)

202,809

Merchandise (2019)

68,355

Office Equipment (2018)

55,000

Office Equipment (2019)

21,138

Other Expenses (2018)

12,893

Other Expenses (2019)

4,059

Rent (2018)

27,000

Rent (2019)

8,000

Supplies (2018)

32,452

Supplies (2019)

5,721

Required:

• Prepare an analysis that shows how cash-based income is converted to accrual-based net income for 2018.
• Prepare an accrual-based income statement for 2018 and a balance sheet as of December 31, 2018 using good form.
• Prepare a brief memo explaining the cash-to-accrual conversion and the results of your calculations.

Answer 1

Q1. Prepare an analysis that shows how cash-based income is converted to accrual-based net income for 2018.

Answer: To arrive at accrual based net income from cash-based income we can use following formula:

= Cash collection from customer + Year end receivable from customer – Advance received from customer for next year sale

Revenue conversion from cash based income to accrual based income
Particulars	Amount $
Collections from customers	356,800
Add: Amount owed by customers at year end	16,500
Less: Collection in advance from customers	(7,000)
Accrual based net income for 2018	366,300

Q2. Prepare an accrual-based income statement for 2018 and a balance sheet as of December 31, 2018 using good form

Answer:

For preparing an accrual based income statement and a balance sheet first we need to prepare the trial balance based on accrual based accounting.

Refer below trial balance prepared basis accrual accounting with working notes so as to understand how the accrual balances arrived at and how complete trial balance is derived.

Accounts title	Working Note	Debit $	Credit $
Common stock	Directly given in question		100,000
Bank Loan	Directly given in question		75,000
Interest payable	Working Note 1		4,375
Advance from customer	Directly given in question		7,000
Accounts payable	Directly given in question		21,000
Wages payable	Directly given in question		7,300
Trade receivable	Directly given in question	16,500
Cash	Working Note 2	68,446
Security deposit given	Directly given in question	5,000
Prepaid Insurance	Working Note 3	2,333
Office Equipment	Directly given in question	55,000
Accumulated depreciation	Working Note 4		9,167
Merchandise inventory	Directly given in question	53,700
Supplies inventory	Directly given in question	6,400
Wages expense	Working Note 5	112,500
Insurance expense	Working Note 3	25,667
Interest expense	Working Note 1	4,375
Depreciation	Working Note 4	9,167
Other expenses	Directly given in question	12,893
Rent	Working Note 6	22,000
Merchandise cost	Working Note 7	170,109
Supplies cost	Working Note 8	26,052
Revenue	Refer answer of part 1 of question		366,300
Total		590,142	590,142

Working Notes:

Working Note 1 - Interest expense and payable

Interest payable on bank loan @10% per year and loan taken on June 1, 2018. Hence for the year 2018 interest is applicable for 8 months. Interest amount will be [$75,000*10%*8/12] = $4,375.

Working Note 2 - Cash balance

Cash balance statement
Particulars	Amount $
Collection from customers	356,800
Proceeds from Bank loan	75,000
Proceeds from sale of common stock	100,000
Wages payment	(105,200)
Security deposit payment	(5,000)
Rent	(22,000)
Insurance	(28,000)
Merchandise	(202,809)
Office equipment	(55,000)
Other expenses	(12,893)
Supplies	(32,452)
Cash balance as at December 31, 2018	68,446

Working Note 3 – Insurance expense: Insurance payment for 12 months of $28,000 is made on 1^st Feb, 2018 hence for the year 2018 it covers 11 month of payment period i.e. expense to the extent of $25,667 [$28,000/12*11] and balance payment amount of $2,333 [$28,000-$25,667] is prepaid insurance.

Working Note 4 – Depreciation expense – As per question depreciation is charged as per straight line basis and the firm uses a convention where one-half year of depreciation is taken in the year of acquisition. In the question the useful life of equipment is not given. For the purpose of computation of depreciation we have assumed that useful life is 3 years considering the basis as firm has taken the premises on rental for 3 years.

Depreciation amount = [$55,000/3 years *0.5 year] = $9,167

Working Note 5 – Wages Expense –

Particulars	Amount
Payment for Wages	105,200
Add: Salaries earned, but not yet paid to employees	7,300
Wages cost	112,500

Working Note 6 – Rent expense – Rent payment for the year 2018 is given in question as $27,000. Also it is mentioned that rent payment for 2018 includes $5,000 as one time security deposit which is refundable after 3 years. Hence Rent expense for the year 2018 would be $22,000. [$27,000-$5,000].

Working Note 7 - Merchandise cost
Particulars	Amount $
Payment for Merchandise in 2018	202,809
Add: Owed to suppliers for merchandise purchase	21,000
Less: Closing inventory of merchandise	(53,700)
Cost of goods sold for Merchandise	170,109

               

Working Note 8 -Supplies Cost
Particulars	Amount $
Payment for Supplies in 2018	32,452
Less: Closing inventory of supplies	(6,400)
Supplies Cost	26,052

Income statement for the year ended on December 31, 2018

Revenue		366,300
Expenses
Merchandise inventory cost	170,109
Supplies cost	26,052
Wages expense	112,500
Insurance expense	25,667
Interest expense	4,375
Depreciation	9,167
Other expenses	12,893
Rent expense	22,000	382,762
Net income		(16,462)

Balance sheet as at December 31, 2018

Particulars		Amount $
Assets
Current assets
Trade receivable	16,500
Cash	68,446
Prepaid Insurance	2,333
Merchandise inventory	53,700
Supplies	6,400
Total Current assets		147,379
Non-Current Assets
Office Equipment	55,000
Accumulated depreciation	(9,167)
Security deposit	5,000	50,833
Total Assets		198,213
Liabilities and Equity
Liabilities
Borrowings	75,000
Interest payable	4,375
Advance from customer	7,000
Accounts payable	21,000
Wages payable	7,300	114,675
Equity
Common Stock	100,000
Retained Earning	(16,462)	83,538
Total Liabilities and Equity		198,213

Q3. Prepare a brief memo explaining the cash-to-accrual conversion and the results of your calculations.

Answer: Cash to accrual conversion mainly involves listing of all the cash payments and cash receipts and ascertaining the time period to which the relevant receipts and payment pertains to. Some of the important points in this regard are:

• Need to ensure that credit sales is recorded and advance from customer is deferred to next period
• Need to ensure that credit purchase is recorded and advance payment to supplier is deferred in next period
• Non-cash events such as depreciation charge, interest accrual, salaries earned but not paid etc. need to record as expense in the current period
• Advance payment of expenses such as Prepaid insurance payment need to book as prepaid for the relevant prepaid period.

Refer answer for sub-part 2 wherein the calculation of cash to accrual conversion along with detailed trial balance is made.

Kindly let me know in comment section in case you need any further clarification in the answer given.