Cash basis accounting had a good run. Now you are stepping up your finance game and it is time to switch your accounting method. Whatever the reason to change your reporting method, know that cash to accrual conversion is intricate. We developed this guide to ease the process.
In this article you will learn:
- The difference between cash vs accrual accounting
- Common events that spark cash to accrual conversion
- An overview of the required IRS form 3115
- How to prepare to convert from cash to accrual with a chart of accounts
- The steps of manually converting an income statement from cash to accrual
- The changes to your financial statements
- How to convert from accrual to cash basis
Cash vs Accrual Accounting Methods
Cash Accounting Method: Follows the principle of recording revenue and expenses as cash changes hands. It is a simple method to follow. However, due to the time difference between revenue and costs, it doesn’t provide a clear financial picture. So there are limitations to knowing future profitability.
Accrual Accounting: Accounting method that follows the matching principle. Meaning revenue and expense transactions must line up in the same period. As well as the double-entry method, where every business transaction makes an equal and opposite change in at least two different accounts. Overall this provides better management of company finances.
When to Change from Cash to Accrual Accounting Method?
There are several events that spur an accounting method change. Some are voluntary events, others are involuntary. Here are the most common reasons to change from cash to accrual accounting:
Voluntary accounting method changes:
- Advanced Payments: Convert to accrual accounting when you are collecting prepayments or holding contracts for longer than a year.
- Becoming a publicly-traded company: Changing your business structure may require adherence to GAAP. These principles are based on the accrual accounting method.
- New Legislation: Sometimes new legislation ignites change. In 2017, the Tax Cuts and Jobs Act (TCJA) increased the revenue threshold for cash basis accounting. Meaning you could file under this method if you made less than $25 million in revenue in 3 consecutive years. It is always good to be cognizant of tax changes, some could be beneficial to your business.
- Loan Application: Traditional banks that offer loans will ask for accrual-based books. It allows the lender to get an overall financial view of the business. They are looking for whether a business can take on additional debt, and have the income to pay it back. Short-term, high-interest loans are available to cash-based businesses. The application asks for bank statements rather than financial statements.
Involuntary accounting method changes:
- Inventory: This is a determining factor for your accounting method. Adding inventory to your business, or changing your inventory method will require IRS filing compliance. That is why most businesses with inventory, start on an accrual basis.
- Audit/IRS Penalty: The IRS has the authority to force a taxpayer to switch from cash to accrual. The change comes when a business is using an accounting method inconsistently, and improperly filing income. It is less favorable to a company and could mean penalties and interest charges. Fortunately, under these circumstances, a taxpayer gets audit protection. This means the IRS will not require a taxpayer to change accounting methods for the same item in the year prior to the change.
Switching from Cash to Accrual Basis Accounting
Overarching Goal—addressing the timing difference of revenue and expenses.
Warning! There is a learning curve to this conversion, it is difficult. The process is extremely detailed and takes a good understanding of accounting. Essentially you are smoothing out major timing fluctuations. This is done by adjusting entries in the current and prior periods.
First, you will need to get IRS approval via Form 3115. If you haven’t filed your first tax return, you may choose your accounting method without IRS approval. Once approved, better brush up on some accounting knowledge. That means organizing your chart of accounts, and understanding debits and credits. Then, start your cash to accrual conversion. Anticipate a slow transition in the first year of change. Each of these steps is detailed below:
Changing Accounting Methods with Form 3115
For cash to accrual conversion, you need to file Form 3115 with your tax return. Do this sooner, rather than later, the IRS needs time to work through any kinks. Generally, extensions are not permitted with this form. Keep in mind there is a 5 year moratorium on changing your accounting method.
Here are some of the things you will need to include when filing:
- Statement of the reason for the requested change
- Income Tax Return of the year of change
- Profit and Loss Statement from previous year
- Balance Sheet from the previous year.
- 481 Adjustment Summary
481 Cash to Accrual Adjustment to Income
On Form 3115, you’ll need to report changes to income on a 481 Adjustment Summary. This shows how specific items that affect income are going to be treated during your accounting method conversion. It ensures that new items will go under the new accounting method and older items with the former method. It will correct issues with duplicating or omitting long-term income items during the transition.
For an adjustment to your taxable income, you will pay or be credited the difference in the tax year when the change occurs. With a positive adjustment, income is increased and these adjustments take place over four years. With negative adjustments income decreases, and is deducted in full, in the year of change. When you are actually doing accounting, you may want to keep these adjustments on a separate spreadsheet. So they don’t affect your formal accrual accounting system.
Building a Chart of Accounts (COA) for Accrual Accounting
Take advantage of the accrual basis accounting method, with a solid chart of accounts. A chart of accounts is a map of all financial accounts in the general ledger. It helps to organize transactions into specific accounting periods. As transactions are reconciled they are funneled into each of your accounts, providing accurate totals for accounting.
Cash basis accounting has only two types of events: revenue and expenses. Transactions recorded in accrual accounting are broken up into 5 event categories: assets, liability, equity, revenue, and expenses. All of your accounts will fall into these categories. Example below:
Follow the balance sheet and the income statement, to start charting your accounts. Each account should be given a name, a description, and an ID code. Accountants like to start asset accounts with the number 1. Please note: your chart should not be overly complex.
Most software programs will start you out with a basic chart of accounts. We are fans of Xero for small business accounting. Their software comes with an intuitive default accrual accounting system. Or it is possible to customize your accounts in Xero.
Having a solid chart is the foundation of your accounting. It will simplify cash to accrual conversion. Most importantly, you will be able to track your finances from year to year. Giving you a better idea of changes in income.
Debits and Credits to the Account Balance
Cash to accrual conversion covers what you are doing in these accounts. Each transaction will impact an account in one of two ways: as a debit or credit. Debits and credits increase or decrease the balance of the account:
Steps for Adjusting your Books from Cash to Accrual Accounting
Step into the main event—accrual accounting! The idea behind converting: we are starting with cash numbers and need to get to accrual numbers. To get there, a number of adjustments are needed for: accounts receivables, unearned revenue, prepaid expenses, and accrued liabilities. You should do this for your first month-end closing procedure on an accrual basis. First, get familiar with these accrual accounting terms:
Accounts Receivable = money that is owed to the business in the current period
Accounts Payable = money that the business owes in the current period
Accrued Expenses aka Accrued Liability = expense that is incurred or reported in the current period, but paid later.
Accrued Revenue = money that is earned but payment is received in a later accounting period.
Prepaid Expense aka Deferred Expense = prepayment of an expense that is reported later in the period.
Deferred Revenue aka Unearned Revenue = prepaid money collected for a service to be delivered or performed in the future.
- Start with the general ledger for the month to convert from cash to accrual
- (+) Add accrued and prepaid expenses
Add any money that has been incurred or prepaid to their corresponding accounts on the balance sheet. These entries will be reconciled in a later period.
- (+) Add Accounts Receivable
We are adding any transactions into accounts receivable because they will occur in a later period. This account shows your responsibilities for the immediate future. It is a major shift from cash basis accounting which doesn’t have accounts receivable.
- (-) Subtract Accounts Payable, Cash Receipts, and Unearned Revenue
We need to take out any transactions from the last accounting period.
- (=) The remaining balance will be your starting point for the next period.
How to do a Cash to Accrual Adjustment?
Keep this in mind, for when you go to make a change in the current period. If you encounter an error in your balance. Take the ending balance in both methods. The difference between the two balances is the adjustment that needs to be addressed in the year of change.
How to Change from Cash to Accrual in Xero
Most accounting action takes place on cloud-based software. So this is where you will be switching your cash balances to accrual. Gather all invoices and bills relevant to the conversion period. Here are the steps to changing from cash to accrual in Xero:
- Got to Accounting and select Advanced
- Select Conversion Balances
- First, enter your conversion date. This is the date you are going to start accrual accounting in Xero. Set it to match the tax year of change.
- Enter conversion balances for all accounts. These are the closing balances on the last day you were using the cash accounting method. They will become the opening conversion balances in Xero. We recommend manually adding balances, so you can go back in and reconcile the remaining balance with your new accrual accounts. Always enter positive numbers. (ex: unpaid customer invoices resulting in a negative accounts receivable balance would be a positive number in the Credit column; A negative bank account balance is entered as a positive number in the Credit column) Debits and credits should zero out. Once completed hit Save.
- Enter historical invoices or bills if you have a remaining balance. These are the unpaid invoices or bills dated prior to your conversion date. They make up the conversion balances of accrued and deferred accounts (accounts payable, accounts receivable, etc).
- Then go to Reports and run a Balance Sheet for your conversion balance date. Ensure all balances match your ending cash balances.
- If you need to make any corrections go back into Conversion Balances, correct the errors and hit Save again.
Steps to Manually Converting Income Statement from Cash to Accrual
To convert an income statement manually, start fresh with the most recent cash basis income statement. Follow these steps to switch from cash to accrual-based accounting:
- Start with cash receipts from the current period for revenue
- (-) Subtract Beginning Accounts Receivable
We subtract the sum of these cash receipts because they were earned in the prior period. They are not relevant to the current period. If they haven’t been paid, they are considered current assets on the balance sheet. If they have been paid they are considered revenue on the income statement.
- (+) Add Ending Accounts Receivable
We add this because it is revenue “earned” in the current period, but has not been paid. They are considered current assets on the balance sheet.
- (+) Add Beginning Unearned Revenue
We collected cash and had a receipt from the prior period. We provided a service and therefore recognized the earnings in the current period. This was considered a liability on the balance sheet. Now it recognized in the current period as revenue on the income statement
- (-) Subtract Ending Unearned Revenue
We collected cash but have yet to provide service. Take this out because the earnings have not been recognized. This is a liability on the balance sheet.
- (=) The sum equals your total accrual-based revenue for the current period
- Next move to cash paid for operating expenses
- (+) Add Beginning Prepaid Expenses
We paid cash in the prior period, but we are recording the expense in the current period since the prepaid service is used. Initially, these prepaid expenses are considered assets on the balance sheet. Once serviced or used, the value is expensed on the income statement.
- (-) Subtract Ending Prepaid Expenses
We paid cash in the current period but the prepaid service has not been used. We are not incurring the expense yet. They are considered assets on the balance sheet.
- (-) Subtract Beginning Accrued Liabilities (accounts payable included)
We incurred the expense in the prior period, meaning we already recorded it. Once it is paid we reverse the entry, but it does not belong in the current period. Liabilities rest on the balance sheet. Once they are paid they are expensed on the income statement. Accounts payable are considered current liabilities on the balance sheet.
- (+) Add Ending Accrued Liabilities (accounts payable included)
We incurred an expense in this period, which we have yet to pay. However, it belongs to the current period. Once paid the entry will be reversed. Liabilities rest on the balance sheet. Once paid they are expensed on the income statement. Accounts payable are considered current liabilities on the balance sheet.
- (=) The sum equals your total accrual-based expenses of the current period
How are Financial Statements Different in Accrual Accounting?
All statements can exist for cash basis accounting. They may not be too useful. While the cash flow statement is virtually the same in both methods. Accrual accounting largely affects the balance sheet and the income statement. This is because of adjusting entries and the revenue recognition process.
On the balance sheet, accrual accounting breaks down assets and liabilities into a multitude of accounts. As money is earned it is categorized as assets or liabilities on the balance sheet. Once the money is recognized it moves to the income statement. This gives a business owner a window into future income or expenses. Likewise, it will affect your net income for taxes.
Is Accrual to Cash Accounting an Automatic Change?
Yes, switching financial statements from accrual to cash is an automatic change in cloud-based accounting software. All reports can be shown in cash basis with a click. Remember though it is NOT an automatic switch with the IRS. As noted above, any change after your first filed tax return must be approved.
As far as tax payments go, there is a major benefit to switching to cash accounting. By eliminating accounts receivable, your income immediately lowers. Which in turn means less income taxes. Something very favorable to small businesses that don’t need to follow accrual accounting.
Steps to Converting from Accrual to Cash Basis
Have a math itch and want to get your hands dirty? Do a manual change from accrual to cash accounting, it is fairly simple. The goal is to record transactions when cash is literally exchanged. These steps show how to convert from accrual to cash basis:
- (-) Subtract Accrued Expenses
- (-) Subtract Accounts Receivable
- (-) Subtract Accounts Payable
Anything that does NOT have an invoice, cash has NOT been received or paid is removed from the period.
- Shift Prior Period Sales
- Shift Customer Prepayments
- Shift Vendor Payments
Payments need to be moved into the period when they were received.
All In On Accrual Basis Accounting
With accrual accounting, remember to report money as it is earned or incurred. This is based on the matching principle. Where all revenue and expenses line up in the same period. As well as the double-entry method, where each transaction has two or more entries. From here on out the balance sheet will be used as a waiting room for adjusting entries. Where transactions mingle as assets or liabilities until they become income or expenses. Congratulations you are now accounting like a pro.