 Hello, and welcome to the session. This is Professor Farhad in which we would look at a CPA questions that deals converting cash basis of accounting to the accrual basis. This is an important topic on the CPA exam. And this question was sent to me by one of my subscribers on farhadlectures.com. If you have a CPA prep course, which you should, if you're preparing for your CPA exam, you should have Becker, Roger, Wiley, Gleim, whatever course you have. If that course is not covering topics and details, if you feel that course is moving too fast, it's covering the material quickly. And that makes sense. CPA courses, they don't teach you the material, they review them. That's why it's called a review course. They review. So if you feel it's going too fast, farhadlectures.com is your solution. So because these courses go too fast, they create a business for me. You want someone that will explain the material slowly in details. And this is what you will find on farhadlectures.com. I have accounting courses, CPA material that's gonna help you move up, move to the speed of your CPA course and supplement the CPA course. Make sure to understand that your CPA preparation is a long-term investment. Don't shortchange yourself. So let's go ahead and start this problem. Before year two, the company used the cash basis. So before year two, we have year one. We use the cash basis. As of December 31st, year two, we changed to the accrual. So now year two, we are using accrual. D, the company cannot determine the beginning balance of supplies inventory. We don't know the beginning balance. What is the effect of the inability to determine beginning supplies inventory on year two, accrual basis and their income? And December 31st, year two, owner's equity. So what's the effect on their income? What's the effect on owner's equity? How can we solve this problem? We don't have any numbers and how are we gonna do so? Well, what affects their income? Two things affect their income, revenues and expenses. Well, supplies has nothing to do with revenues. We need to look at our expenses. Specifically, we need to examine our supplies expense. How do we compute our supplies expense? Well, how do we compute supplies expense? We compute supplies expense by taking beginning inventory at the supplies, the purchases that we made for that year. And that's gonna give us available supplies. And from available supplies, we count the supplies that's left and we subtract ending supplies and we come up with supplies expense. So this is the formula for computing supplies expense that affect their income. So how is that gonna help us? Well, let's throw some numbers and see how this all works. Let's assume we know beginning inventory and let's assume beginning inventory is 1,000. Let's assume we know beginning inventory, it's 1,000. Let's assume, well, let's not assume anything. We should know our purchases and let's assume our purchases is 1,500. 1,000 plus 1,500 equal to 2,500. That's the available supplies we had. Then if we, let's assume we counted our ending inventory and we determined that we still have 600 of ending inventory. We still have 600 of ending inventory. That's gonna be deducted. If we still have 600, it means we consumed 1,900 of supplies expense. That's what it means. Now, this is in the normal scheme of things. What is the situation here? The situation is we don't know beginning inventory. So how do we deal with this? Well, guess what? Year one, we have to understand we were using the cash basis. And there's something you need to know about the cash basis. And what is the cash basis? The cash basis is you expense all your cash expenditure. So what does that mean? Whatever you did in year one, whatever you did in year one, it doesn't matter whether you purchased 500, 5,000 or 50,000 of supplies. If you're using the cash basis of supplies, you are going to expense all of it. Therefore, year one, the number that you have for year one for expense is everything is expensed. What does that mean? It means you have no, no ending supplies inventory, no ending, you have no ending of supplies. Why? Because you've expensed everything. Well, if you have no ending supplies, it means you have no beginning supplies. Therefore, if you have no beginning supplies, it means beginning supplies for year two is zero. Now let's go through our computation. If your beginning supplies is zero, you purchased 1,500. It means you had available for sale on the box 1,500. You counted your inventory and you still have 900. It means your supplies expense under this scenario is 900. Well, hold on a second. What happened to your supplies expense? Your expense went down. Your expense went down. If your expense went down, it means your net income is inflated, is overstated. Well, immediately we can eliminate A, we could eliminate B and now we're down to C and D. And this is the tricky part. So you're down to C and D. Logically speaking, logically speaking, when you say my net income is up, you're gonna say if my net income is up, automatically you are thinking, which is you are correct in your thinking, but you have to be careful your equity is up as well. So you would say, don't rush though. You would say, oh, my net income is overstated. Oh, therefore my equity is overstated. That's a general statement true, but here you are not talking about one particular year. You are talking about year two. Owner's equity in contrast to expense is a cumulative account. You have to be very careful. Equity is cumulative. Equity is a balance sheet account. What does that mean? It means whatever happened in year one, let's assume in year one, in year one what happened is you overstated your expenses. So in year one what happened is you overstated your expenses in year one by whatever number. It doesn't matter what number it is. You overstated your expenses. Supplies expense to be more specific. By overstating your supplies expenses, you understated your net income. Therefore you understated your owner's equity. It doesn't matter what amount. Let's assume by a thousand. Let's assume use the number. Let's assume by a thousand. Your expenses are by a thousand. Your net income up by a thousand. Therefore your equity is down by a thousand. In year two, notice what happened. In year two the kind of the error or the effect of that overstatement reversed itself. In year two, because you did not have beginning inventory what happened technically in year two, your expenses are understated by a thousand. Just showed you your net income is overstated by a thousand. As a result your owner's equity is overstated by a thousand. What does that mean? It means the cumulative between year one and year two it went up by a thousand. It went down by a thousand. What's the effect on equity? Zero effect on equity. Therefore the answer will be C. So you have to be very careful what they're asking. What they're asking. If they ask what is the effect on owner's equity year one, then that's different. Year one, your expenses were higher. Your income goes down. Your equity is higher. But they're not asking about year one. They're asking about owner's equity year two. So you have to take into account what happened in year one. What's the effect of year one on the equity in year two? So it's very important to differentiate between those two. Now again, as I said, we did not use numbers here. And on the exam you can't go through all this. This is the reason I did all this explanation so you understand the logic behind it. So once you get another question like this, you are ready to move quickly. You're ready to move quickly. Immediately what you should do when you see a problem like this. When you real quick, here's the fast way to think about this. Okay, I switched from cash to a cruel. Well, everything was expense. I have no beginning inventory. If I have no beginning inventory, my expenses will be understated. Well, therefore my net income will be overstated. So you're down to 50-50. Down to 50-50 and you have to understand that equity is a cumulative account. What happened in year one will reverse in year two. No effect. But again, on the exam that you have to move quickly, but once you understand the concept, you'll be able to do so. Now how can I help? Once again, farhatlectures.com. This is what I do. I explain those topic in details. Cash to a cruel, a cruel to cash or the statement of cash flow. That's very important concept to understand when you walk into the exam. Once again, your CPA is not an expense. Your CPA preparation is an investment. It's an asset that's gonna pay dividend for 20 to 30 years. Don't shortchange yourself. I can help you improve your grade by 10 to 15 points on your exam and accompanying your CPA prep course and put that exam behind you and move on with your life. Good luck, study hard and stay safe.