The accrual basis of accounting is used to record revenues and expenses in the period in which they are earned, irrespective of the timing of the associated cash flows. However, there are times (usually involving the preparation of a tax return) when a business may instead want to report its results under the cash basis of accounting; the cash basis involves only recording transactions when the cash related to them is either paid out or received. How do we convert accrual basis accounting records to the cash basis?
To convert from accrual basis to cash basis accounting, follow these steps:
- Subtract accrued expenses. If an expense has been accrued because there is no supplier invoice for it, remove it from the financial statements. The easiest source of this information is the accrued liabilities account in the balance sheet. Be sure to first examine the contents of this account to ensure that it is correct.
- Subtract accounts receivable. Do not include any accounts receivable and their related sales if the related cash was not received within the period.
- Subtract accounts payable. Do not include expenses for any accounts payable that were not actually paid in cash during the period.
- Shift prior period sales. Under the accrual basis, some sales may have been accrued at the end of the preceding period. If the related customer payment was not received until the following period, shift these sales forward into the accounting period when cash was actually received. This may require an adjustment to the beginning retained earnings account.
- Shift customer prepayments. If customers paid in advance for their orders, these payments would have been recorded as liabilities under the accrual basis. Shift these transactions to sales in the period when the cash was received.
- Shift prepayments to suppliers. If the company pays in advance for some expenditures, these payments would have been recorded as prepaid expenses under the accrual basis. Shift these transactions to expenses in the period when the cash was paid.
The changes itemized above should not be entered into the accounting records of the business, unless you really want to change the entire system over to the cash basis permanently (which usually also requires the reconfiguration of the accounting software). Instead, enter these changes on an electronic spreadsheet, and manually calculate the revised financial results for the cash basis of accounting. Be sure to password-protect and backup this spreadsheet, in case it is ever called into question as part of a tax audit.
Also, be aware that the use of the cash basis for tax reporting purposes is limited by the IRS to smaller organizations that do not report any inventory at the end of their fiscal years. Consequently, do not engage in this conversion until you have researched whether the IRS will allow it for your tax reporting.