Businesses manage their finances using either cash or accrual basis accounting.
One of the most complicated concepts to understand in accounting is converting a set of accrual-based books for a cash basis tax return.
Accrual accounting is the standard for more complex businesses for bookkeeping purposes since it demonstrates the real-time performance of the entity. The books’ records should show cash collected and expenses paid plus amounts earned and expenses payable for the particular period.
Unlike the accrual accounting, the cash method requires you to record the money earned and expenses paid.
Hence the conclusion: the cash basis does not generally allow accounts receivable and accounts payable; there are no prepaid expenses either.
Sometimes, it might be necessary to perform accrual to cash conversion for the following reasons:
a) The company has to file tax returns on a cash basis.
b) Reconciliation of accrual accounts with cash accounts is needed.
Accrual to Cash Example
Let’s assume, and Alan runs a business that supplies his clients with gadgets. In November, Alan signs a contract with a new customer. According to the contract, the customer will pay Alan $300 per month on the delivery of the goods from the following month of December. Under the cash system of accounting, there would be no income in November, although Alan ships his goods that month.However, on an accrual basis, Alan would book the $300 as revenue the same month of November, although he doesn’t receive the money till December.
Accrual to Cash Conversion Formula
We use formulas to reflect the accrual to cash conversion. The accounts that should be deducted from financial statements in the conversion process are shown below:
- Outstanding Expenses
- Outstanding Income
- Accounts Receivable
- Accounts Payable
At the same time, the following accounts should be added to financial statements:
- Advance Income
- Advance Expenses
However, there is a more natural way of doing this. Rather than deducting or adding accounts, we take the net income, total assets and total liabilities and make adjustments for conversion from the accrual to the cash system.
Other Useful Accrual to Cash Conversion Formulas
The following formulas represent the conversion of accrual to the cash basis income statement.
The terminology used in the formulas is shown below:
BB – Beginning balance
EB – Ending balance
AR- Accounts receivable
AP – Accounts payable
MI – Merchandise inventory
PE – Prepaid expenses
AE – Accrued expenses
- Sales revenue + BB AR – EB AR = Cash sales
The formula for merchandise inventory payments would look like this:
- Cost of goods sold + EB MI – BB MI + BB AP – EB AP = Cash payments for MI
- Expenses + EB PE – BB PE + BB AE – EB AE = Cash payments for Expenses
Conversion to the cash system requires one to subtract all the transactions recorded but not yet received or paid from the totals on the income statement. That means subtractions of all accrued expenses, including accrued tax liabilities and purchases, total accounts receivable, and accounts payable amounts. You will record these when the money changes hands.
If customers have prepaid for goods or services, you will record these payments as liabilities in an accrual system, but they count as sales if you’re using a cash basis.
With a cash basis method, you always know how much money your business has at any particular time. You should record your income and expenses as they incur. The smaller businesses are more likely to use the cash system of accounting.
Under an accrual basis accounting, you will record your income when the financial transaction happens but isn’t paid until the following month. The use of relevant formulas here is a must. By using this method, you get a better sense of your company’s profitability pace.