How To Change From Cash to Accrual

Many small businesses use the cash method of accounting because it is the easiest way to track revenue and expenses. The complex accrual method requires a greater understanding of accounting principles, but reported results are usually more accurate. As a small company grows, a cash to accrual method change may be required for tax purposes. Also, companies maintaining inventory generally must use the accrual method of accounting. When a change in method is called for, a cash to accrual conversion occurs through a series of adjusting entries.

A Quick Overview of Cash and Accrual Basis Accounting

The choice between cash and accrual accounting may depend on various factors such as the size of your company, whether or not you hold inventory, and legal or tax requirements. Cash accounting is often the easiest method for small companies to use, as they only record a transaction when cash is sent or received. Using the cash method, if you make a sale, you count the related revenue when the cash payment is received from your customer.

Alternatively, the accrual method takes into account when revenue is actually earned. This may or may not be when a cash payment is received. If you make a sale under the accrual method and send an invoice to a customer, you can count the sale at that time; you do not need to wait for the customer to pay.

The same methodology can also be used to explain the recording of expenses under the cash versus accrual method. When you pay a bill under the cash method, you can record the entire expense at that time. Under the accrual method, rather than record an expense when you send a payment out the door, you'll need to recognize the costs to your business as they are incurred. This pairing of revenues earned and expenses incurred is the basis of the matching principle, a fundamental premise of the accrual method of accounting.

Matching revenues and expenses under the accrual method could mean paying an insurance bill for an annual policy at the beginning of the year, but recognizing the related expenses in twelve monthly installments for accounting purposes.

How To Change From Cash to Accrual Accounting

If you're considering a cash to accrual method change, you'll need to think through the process ahead of time. Shifting from the single-entry cash system to a double-entry accrual system means booking additional entries for accrued and prepaid amounts that represent income earned or expenses incurred.

Converting from cash to accrual accounting can be time-consuming and frustrating for small-business owners without an accounting background. Your accounting software may offer a built-in capability to assist you with the change in accounting method from cash to accrual.

Step 1: Begin With an Understanding of How To Create an Accrual Accounting System

To convert from the cash to accrual method, the first step involves gaining an understanding of the underlying reason for the change—a better matching of revenues and expenses. When using the cash method of accounting, revenue and expenses are recognized only when cash is received or paid. Yet, modern conveniences have allowed for more flexible payment options in addition to the remittance of cash at the point of sale. Thus, a company's cash balances do not always move in sync with revenue. Revenue accruals can be used to record sales income earned when cash has not yet been received.

On the expense side, accruals and prepaid accounts may also be used. Businesses may choose to pay one lump sum to vendors and take delivery of supplies throughout the year. This would be recorded as a prepaid expense. As the supplies are used to help generate sales throughout the year, the related expenses would be recognized in the financial statements and matched against revenues. In this way, revenue is captured when earned and expenses are recognized when incurred, not necessarily when paid for.

Step 2: Determine Which Accounts Are Affected

Take a look at your existing balance sheet and income statement to determine how you currently report assets, liabilities, revenues, and expenses. Next, you'll need to find any accounts that will require a cash to accrual adjustment. Generally, you'll add accounts receivable and accounts payable to your financial statements, as well as prepaid accounts for both income and expenses. A chart of accounts should be created to include each line item used for the accrual method of accounting.

Step 3: Make Adjusting Entries To Convert Existing Records From Cash to Accrual Accounting

Once you have a list of all the accounts in your record keeping system, you'll need to adjust the existing line items to reflect the new accounting method. Under the cash method, a sale made where payment has not yet been received would not be recorded on your accounting records. However, under the new accrual method, the sale will be included as a revenue, with a corresponding account receivable that will remain on your books until the cash payment is received.

Step 4: Incorporate New Accounting Procedures To Maintain an Accrual Basis System

Make sure everyone who records financial transactions for your company is aware of the new method and new procedures. If you use accounting software, it should be updated with a new chart of accounts. You should plan to review month-end statements to make sure that all transactions are hitting the right accounts and properly balanced.

Step 5: Conduct Audits or Reviews To Check for Errors

As with any complex change to record-keeping procedures, it's natural to expect a few accounting errors to pop up when you convert from cash to accrual. During the first months, you may need to heavily review your financial statements to ensure that they properly reflect the new accounting method. Going forward, you can build self-checks and audits into your bookkeeping system to catch mistakes and correct them.

Accounts Affected by a Cash to Accrual Conversion

Depending on the number of accounts a company maintains in its bookkeeping system, a cash-to-accrual conversion may require several adjusting entries. Once the new method is established, accrual accounts are updated at the end of each accounting period. Here is a look at some of the accounts which may be affected.

Accounts Receivable

Under the cash method, cash received from customers is the sole basis for revenue recognition. Conversely, under the accrual method, sales income may be recognized even if a company has not received a cash payment. How is this new revenue amount determined? The accounts receivable register is often the best way to identify revenue earned but not yet received.

Customer Prepayments

Some companies request a partial prepayment for a job before work is begun. Under the cash method of accounting, any down payments or prepayments are recorded as revenue when received. But when you are aiming for revenue recognition under the accrual method, customer prepayments are classified as a liability on the balance sheet and only taken to income when the relevant work is complete.

Accounts Payable and Other Accrued Expenses

Under the cash method of accounting, expenses are recognized when bills are paid. At year end, bookkeepers may have received bills for expenses incurred in December that are not paid until the next fiscal year. In this instance, if a company follows the accrual method, an accounts payable account is set up on the balance sheet as a liability and the balancing entry increases expenses. Once the bills are paid, the accounts payable account decreases, along with cash.

Aside from the amounts listed as accounts payable, other expenses may also need to be accrued at the end of an accounting period. Items such as payroll expense may be earned by employees during the last weeks of the year, but not paid until after year end. The wages earned should be reported as an accrued expense. In this way, expenses incurred in one year are properly matched with revenues from the same period.

Prepaid Expenses

Cash method bookkeepers may generally expense bills as paid, even if a bill is paid in advance. Under the accrual method, when a company pays for an expense prior to actually receiving the benefit of the expenditure, a prepaid asset must be set up. Some examples of prepaid expenses include monthly rent, (when the entire lease is paid upfront), insurance policy premiums which cover six months or a one-year period, or bulk purchases of office supplies.

When Should a Company Switch From Cash to Accrual?

The decision to switch from cash to accrual accounting comes with a time investment and can have lasting ramifications. Companies may decide to make the switch on their own if the owners or management believe the financial statements will more properly reflect the profitability of the business using accruals. Other reasons to switch include legal, tax, or industry reporting requirements. If you do change your accounting method, you'll need to inform the Internal Revenue Service by filing Form 3115.

Use the Best Method for Your Needs

The accounts above provide examples of adjustments needed for a cash-to-accrual conversion. When using online accounting software, checks and balances built into the double entry system ensure that accrual entries are entered correctly and properly balanced. An accounting or tax professional can provide additional advice on the conversion process and how this change affects a company's financial statements.

As a small business, you want your financial reporting to be clear, efficient, and understandable. While cash accounting is viewed as a simpler method of reporting, accrual accounting may actually do a better job of accurately reflecting your financial position. This can provide an advantage when raising capital, applying for a loan, or soliciting new investors.