When you started your business, you might have chosen to use cash-basis accounting. Cash basis is the simplest way to record your books. It is good for new businesses with few transactions.
You might consider switching to the accrual accounting method as your business grows. Accrual accounting offers several perks for financial management. And if your business grows to a certain size, you might be required to use accrual accounting.
Learn how to convert your books from cash-basis to accrual accounting. But first, consider the differences between the two accounting methods.
Difference between cash basis and accrual
There are several key differences between cash basis and accrual. Depending on which method you use, you recognize transactions at different times.
Cash-basis accounting is a single-entry bookkeeping method. For every business transaction, you make one entry. Record money when it changes hands. When you receive a payment, record the income. When you make a payment, record the expense.
Accrual accounting is a double-entry accounting method. You record at least two opposite and equal entries for every business transaction. Each entry is either a debit or credit. Debits and credits increase or decrease the accounts in your books, depending on the account.
Cash-basis accounting is a simpler bookkeeping option. Accrual accounting tends to be more accurate and gives a clearer picture of your long-term finances.
How to switch from cash basis to accrual
To convert your books from cash basis to accrual, you will need to complete several tasks. First, you must adjust your books to reflect the accrual method. You must also fill out and file a form with the IRS to request the change.
Adjusting your books
If you decide to switch your books from cash basis to accrual, you must adjust your records. In accrual accounting, you account for incurred income and expenses.
A cash-to-accrual conversion can be broken down into several steps. When you go from cash basis to accrual basis, do the following:
- Add accrued and prepaid expenses
- Add accounts receivable
- Subtract cash payments, cash receipts, and customer prepayments
#1. Add accrued and prepaid expenses
Accrued expenses, or accrued liabilities, are benefits you incurred but have not paid for yet. For example, you receive materials from a supplier, and they invoice you. You benefit from the goods now, but you won’t pay for them until a later date.
To switch to accrual, record any accrued expenses, such as unpaid bills and wages earned by employees who you have not paid yet.
Prepaid expenses are cash payments you made that relate to assets you haven’t used up yet. You pay for something in one accounting period but don’t use it right away. For example, insurance is often a prepaid expense because you pay up front and use it over a period of time.
When you convert to accrual accounting, move any prepaid expenses from the current accounting period to an asset account.
#2. Add accounts receivable
Accounts receivable (AR) is money owed to your business. If you provide a good or service and invoice a customer, you gain a receivable. The invoice amount remains a receivable until the customer pays you.
With cash-basis accounting, you do not record accounts receivable in your books. To switch to accrual, add any unpaid customer invoices to your books. Once the invoice is paid, move it to a revenue account.
#3. Subtract cash payments, cash receipts, and customer prepayments
Some transactions need to be subtracted when you switch to accrual accounting. These entries include cash payments, cash receipts, and customer prepayments.
Cash payments mean any cash you paid for expenses. To convert to accrual, subtract cash payments that pertain to the last accounting period. By moving these cash payments to the previous period, you reduce the current period’s beginning retained earnings.
Cash receipts received during the current period might need to be subtracted. If a sale began in a previous period and you received cash in the current period, you need to reverse the sale in the current period and record it as a receivable in the last period (when the sale occurred). When subtracting cash receipts, adjust the current period’s beginning retained earnings.
Customer prepayments are payments received before you deliver a product or service. In cash accounting, the prepayment is entered as a sale. For accrual accounting, record the prepayment as a short-term liability until you provide the good or service.
Cash to accrual conversion examples
Take a look at the following cash-to-accrual conversion examples.
Cash to accrual conversion example 1: Revenue
Let’s say you make a sale and invoice the customer for $800. In the same accounting period, you receive $200 from the customer. Record these entries in your books:
| Acount | Debit | Credit |
|---|---|---|
| Cash | 200 | |
| Revenue | 200 | |
| Total | 200 | 200 |
With cash basis, you only record the money you actually receive from the customer ($200). The $600 difference from the sale does not appear in your books because you have not received it yet.
To convert your books to accrual at the end of the period, recognize the outstanding sales due.
| Acount | Debit | Credit |
|---|---|---|
| Accounts Receivable | 600 | |
| Revenue | 600 | |
| Total | 600 | 600 |
The cash-to-accrual conversion entry fixes the accounts receivable account. It shows the $600 still outstanding from the customer. The entry also increases revenue to show the total sales for the period.
Cash to accrual conversion example 2: Expenses
Let’s say a supplier invoices you for $500 during the accounting period. In that same period, you pay $200 to the supplier. Record the following entries:
| Acount | Debit | Credit |
|---|---|---|
| Expenses | 200 | |
| Cash | 200 | |
| Total | 200 | 200 |
In cash basis, you only recognize the amount you actually paid. You do not reflect the remaining $300 balance you owe in your books.
Recognize the outstanding amount you owe to convert your books to accrual at the end of the period.
| Acount | Debit | Credit |
|---|---|---|
| Expenses | 300 | |
| Accrued Expenses Payable | 300 | |
| Total | 300 | 300 |
The cash-to-accrual conversion entry fixes the accrued expenses payable account. It shows the $300 you still owe to the supplier. The entry also increases the expense account to show the total expenses for the period.
Form 3115 cash to accrual
You informed the IRS of your accounting method when you filed your first small business tax return. To request a change in your accounting method, use Form 3115.
You can file Form 3115 any time after the first day of the year. The earlier you file the form, the more time the IRS has to work through any issues.
Attach your profit and loss statement and balance sheets from the previous year to Form 3115. Include any adjustments you made to your books with the form as well.
When you fill out Form 3115, you report the section 481 adjustment. The 481 adjustment corrects issues with duplicating or omitting transactions during the transition. The section 481 adjustment reflects the changes you made to your books when switching from cash basis to accrual.
Which accounting method do you prefer—cash basis or accrual? Patriot’s online accounting software offers both cash basis and accrual functions, so you can easily implement it into your bookkeeping processes no matter what method you use. We offer free, USA-based support. Try it for free today.
This article has been updated from its original publication date of November 28, 2017.
This is not intended as legal advice; for more information, please click here.
