Many small businesses use the cash method of accounting because it is the easiest way to track revenue and expenses. The more complex accrual method requires a greater understanding of accounting principles, but reported results are usually more accurate. Yet, as a small company grows, the accrual method 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.
Begin with an Overall Picture of Changes
To convert from the cash to accrual method, the first step involves gaining an understanding of the difference between the two methods. When using the cash method of accounting, revenue and expenses are recognized only when cash is received or paid. Yet, modern payment conventions have allowed for more flexible 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. On the expense side, businesses may choose to pay one lump sum to vendors and take delivery of supplies throughout the year as needed. The accrual method of accounting seeks to incorporate cash payment versus revenue differences. Revenue is captured when earned and expenses are recognized when incurred, not necessarily when paid for.
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 only require a few 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.
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 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.
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 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.
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.
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.