Question

On April 1 Ivy Corp began operating a service company with an initial cash investment by shareholders of $1,000,000. The company provided $3,200,000 of services in April and received full payment in May. Ivy also incurred expenses of $1,500,000 in April that were paid in June. During May, Ivy paid its shareholders cash dividends of $500,000. What was the company's income before income taxes for the two months ended May 31 under the following methods of accounting?

Cash Basis Accrual Basis
a) $3,200,000 $1,700,000
b) $2,700,000 $1,200,000
c) $1,700,000 $1,700,000
d) $3,200,000 $1,200,000

Answer 1

Under cash basis accounting, the income before income taxes is $3,200,000. Under accrual basis accounting, the income before income taxes is $1,700,000.

Option 'A' is the correct

Step-by-step explanation:

The income before income taxes for the two months ended May 31 under cash basis accounting can be calculated by considering the cash inflows and outflows during the period.

In April, the company provided $3,200,000 of services, which is the revenue for that month. As the payment was received in May, this cash inflow is also considered in May.

There were no cash payments for expenses in April, so the total revenue of $3,200,000 is the income before income taxes under the cash basis.

Under accrual basis accounting, we consider the revenue when it is earned and the expenses when they are incurred, regardless of the timing of cash flows.

Therefore, the revenue of $3,200,000 from April is recognized in April itself. Similarly, the expenses of $1,500,000 incurred in April are also recognized in April.

Hence, the income before income taxes under accrual basis accounting is $3,200,000 - $1,500,000 = $1,700,000.