Converting to the Accrual Basis (#327)
/How do you convert from the cash basis of accounting to the accrual basis Under the cash basis, you recognize revenue when cash is received, and expenses when cash is paid. Under the accrual basis, you recognize revenue when it’s earned, and expenses when they’re incurred. So, the timing of revenue and expense recognition can be totally different.
Doing the conversion from the cash basis to the accrual basis is pretty common, since small businesses typically start with the cash basis, and then flip over to the accrual basis when they get larger. You might need the accrual basis in order to convince a lender to issue a loan, or maybe because an acquirer wants to see your financials prepared under the accrual basis.
Step 1. Add Accrued Expenses to the Financials
The conversion involves six steps. First, you have to add accrued expenses to the financials. This means adding back all expenses for which the business has received a benefit but hasn’t yet paid the other party. You should accrue for all types of expenses, such as wages earned but unpaid, direct materials received but unpaid, office supplies received but unpaid, and so on.
Step 2. Subtract Cash Payments
The second step is to subtract cash payments. This means subtracting out cash expenditures made for expenses that should have been recorded in the preceding accounting period. It also means reducing the beginning retained earnings balance, which thereby incorporates these expenses into the earlier period.
Step 3. Add Prepaid Expenses
The third step is to add prepaid expenses. Some cash payments might relate to assets that haven’t yet been consumed, such as rent deposits. You should review expenditures made during the accounting period to see if there are any prepaid expenses, and move the unused portion into an asset account. If you want to do the same for expenditures made in prior periods, then adjust the beginning retained earnings balance to remove the expenses that are now being shifted into a prepaid expenses asset account.
Step 4. Add Accounts Receivable
The fourth step is to add accounts receivable. This means recording accounts receivable and sales for all billings issued to customers and for which no cash has yet been received. This can be time-consuming, depending on sales volume.
Step 5. Subtract Cash Receipts
The fifth step is to subtract cash receipts. This is because some sales originating within a prior period might have been recorded in the current period, because the related cash was received in the current period. If so, reverse the sale transaction and record it instead as a sale and account receivable in the preceding period. To do this, you’ll need to adjust the beginning retained earnings balance.
Step 6. Subtract Customer Prepayments
And the last step is to subtract customer prepayments. You may not have to worry about this one at all, but customers might have paid in advance for their orders, which would have been recorded as sales under the cash basis of accounting. You should record them as a liability until the related goods have been shipped.
Additional Conversion Issues
So, that’s obviously a lot of work. And it’s worse than you think, because you might not catch everything that needs to be converted. The only way to be certain is to examine every single transaction during the year being converted, and in the final quarter of the preceding year. Which might be a huge amount of work.
To make things even more difficult, a small business tends to not have an overly well-run accounting department, which means that its accounting records aren’t exactly well documented. Which makes it more difficult to figure out if a transaction needs some kind of adjusting entry.
So, what is the strategy for this? How do you go about actually doing the conversion? There’s clearly a lot of work involved, and you might not have enough staff to do it. A couple of options are available.
One is to hire an accounting firm to go through your records and figure out the entries that need to be made, and then make a bunch of one-time entries to flip over to the accrual system. I recommend this approach, because you’re getting people to do it who have – hopefully – done it before, and so are less likely to make mistakes. It also means that you’ll be able to start with a fairly reliable set of accrual basis financials as of a designated date.
Another possibility is to work your way into it gradually. This could work if you want to do everything in-house, which might even be the only option if you can’t afford to have an accounting firm do it for you.
This might sound a bit unorthodox – and it is – but a possibility is to slowly go through each of those six steps that I outlined, and gradually convert over. What that means is that the final year under the cash basis of accounting would actually be done in accordance with a hybrid of the cash and accrual systems, which is not allowed by any accounting framework. But, if you just want to take your time and slowly roll out the conversion, and no one is especially concerned about the results you’re posting during that transition period, then you could try this option. The main advantage is that you can get by with the minimum amount of resources over a more extended period of time.
The final option is to keep the work in-house, do the research in advance of the conversion date, and run the same journal entries that an outside accounting firm would use if you had hired them instead. The benefit here is that you’re not paying the fees of the outside accountants. The downside is that – presumably – no one on staff has done this before, so the risk of making a mistake is higher.
To avoid the mistakes associated with any type of in-house conversion, you might consider hiring an accounting firm just to check your proposed entries, to see if anything is wrong or missing. There will be a fairly hefty billing for doing this, but it’ll be much smaller than if you hired the accounting firm to do the entire project.
