Businesses manage their finances using either cash basis of accounting or accrual basis of accounting. These two methodologies are different in their approach towards recording revenues, expenses, and subsequently income. Although the most widely used basis of accounting tends to be an accrual basis, many companies tend to switch to the cash basis of accounting.
To understand the transition from the accrual basis of accounting to the cash basis of accounting, it is important to understand the underlying difference between the accrual basis and the cash basis of accounting.
What is the Accrual basis of accounting?
The accrual basis of accounting refers to a standard of bookkeeping that requires revenues for a particular period to be matched with the expenses of the given period. This particular approach requires both revenues and expenses to be recorded in the period in which they are incurred. This is irrespective of the timing associated with the cash flows.
Accrual Basis is most commonly used by companies across the globe, primarily because of the matching concept. Revenues of a particular period should be compared to the expenses of a particular period to get the correct idea of the company’s profitability over a certain period of time.
What is the Cash basis of accounting?
The cash basis of accounting, unlike the accrual basis of accounting, follows the premise of recording revenues and expenses in the period where cash is received, as opposed to accounting periods where the revenue and expenses are actually incurred.
Therefore, the main premise under this particular reporting system involves recording cash expenses and revenues in periods where they are earned, as opposed to periods when the expenses and revenues are actually incurred.
The underlying difference between the cash and the accrual basis of accounting is that the cash basis of accounting does not hold any accounts receivables or payable. In contrast, the accrual basis of accounting has deferred revenues and expenses.
How to convert from Accrual Basis of Accounting to Cash Basis of Accounting?
To convert from the accrual basis of accounting to the cash basis of accounting, the following steps need to be undertaken:
- Adjusting for Accrued Expenses: In order to adjust from accrual basis of accounting to cash basis of accounting, accrued expenses need to be subtracted from the financial statements. In the case where there has been accrued expense because of absence of a supplier invoice, it is necessary to remove it from the financial statements. The source from where this information is easily obtained is the accrued liabilities account in the balance sheet.
- Adjusting for Accounts Receivables: In order to covert from accrual basis to cash basis of accounting, adjusting for accounts receivables is also highly important. All accounts receivables are supposed to be removed from sales, if the cash for these transactions was not received in the given period.
- Adjusting for Accounts Payable: Similar to accounts receivables, accounts payable also need to be adjusted from the financial statements. Only those transactions are supposed to be included in the financial statements for which the cash was paid as a settlement in the given year. This implies that only those expenses are included in the financial statements that are settled for cash in the respective period.
- Adjusting for prior period sales: Under accrual basis of accounting, sales are often accrued at the end of the preceding period. In the case where the payment for these particular sales was not received in the following period, then it is important to shift these sales back to the next period, when cash for these sales would actually be received. Therefore, the need to make the adjustments is mainly rooted in adjusting the current period sales, with the cash payments that have been received in the given period.
- Customer Prepayment Adjustment: In the case where customers had already paid in advance for their orders, their payments would be recorded as accrued revenue under the accrual basis. Under the cash basis, it is important to record these transactions to sales, corresponding to the period when the cash was received for these orders.
- Supplier Prepayment Adjustment: Similar to prepaid revenue (that was recorded as a Current Liability under the Accrual Basis of Accounting), prepaid expenses also need to be adjusted. In the case where there are prepaid expenses by the company (under Accrual basis of accounting), it is required to shift them back to expenses.
The above-aforementioned adjustments are required to enable a smooth transition between the accrual basis of accounting and the cash basis of accounting. These adjustments basically include removing all the deferred and advance payments and completely being reliant on cash-related payments.
Accrual to Cash Conversion Formula
Accountants use certain formulas to depict the shift from an accrual basis to a cash basis. This makes the overall shift from accrual to cash relatively easier.
The formula basically categorizes accounts (and their respective amounts) that should be deducted from the financial statements and accounts (and their respective amounts) that should be added back to the financial statements. The conversion process is summarized as follows.
Amounts that should be deducted from the financial statements are as follows:
- Accrued (or outstanding) expenses
- Outstanding Income (income not yet settled for by debtors)
- Accounts Receivable
- Accounts Payable
In the same manner, the following accounts are supposed to be added back to the financial statements:
- Advanced Income
- Advance Expenses (Prepaid Expenses)
Additionally, to change specific line items in the financial statements from accrual basis to the cash basis of accounting, the following formulas are used:
- Cash Sales = Sales Revenue + Beginning Balance of Accounts Receivables – Ending Balance of Accounts Receivables
- Cash Payments for Purchases (Merchandise Inventory) = Cost of Goods Sold + Ending Balance of Merchandise Inventory – Beginning Balance of Merchandise Inventory + Beginning Balance of Accounts Payable – Ending Balance of Accounts Payable
- Cash Payment for Expenses = Expenses in the Income Statement + Ending Balance for Prepaid Expenses – Beginning Balance for Prepaid Expenses + Beginning Balance for Accrued Expenses – Ending Balance for Accrued Expenses
In the formulas mentioned above, it can be seen that the main rationale is to subtract transactions that are recorded in the financial statements but not yet settled in cash from the financial statements. Therefore, this mainly requires changing all prerecorded revenues and expenses to the ones that have already been settled in cash.
Another simple approach of converting from accrual to cash basis might be to inspect the bank statements and compare cash incoming with cash outgoings. The net amount can then be identified as profit earned for the particular accounting period.
Conversion from accrual to cash basis is often undertaken by companies that need to get a better idea of the company’s profitability in terms of the cash that companies have raised over time.
Furthermore, it is also important to consider the fact that several different heads of accounts are included in the accrual basis of accounting, not the cash basis of accounting.
For example, accrued expenses and payments. Sometimes companies need to get an idea of the actual business carried out in terms of cash, and hence, they prefer switching to a cash basis to get a better idea.
