Accounting 101

Understanding Accrual to Cash Conversions

Converting from the accrual to cash basis.

One of the most complicated concepts to understand in accounting is converting a set of accrual based books for a cash basis tax return. This article is intended to cover basic concepts of an accrual to cash conversion and discuss how to properly report business income on a cash basis when given a set of accrual basis books.

Accrual Method of Accounting

The accrual method of accounting is the method in which income is recognized when it is earned and expenses are recognized when they are incurred regardless if cash was exchanged.  Below are several key terms used with the accrual basis.

Accounts Receivable: represents amounts that have been earned but not yet collected. For example, if a business sold a product or service and the customer is given 30 days to pay the balance, then the amount is considered income on an accrual basis.

Prepaid Expenses: represents amounts paid in cash but not yet incurred as expenses. For example, if you prepaid insurance for the year then you should show the expense evenly throughout the year and not just on the date it was paid. This matches the payment of cash with the expense incurred.

Deferred Revenue: represents amounts collected in cash but not yet earned. For example, if you received money for a product or service that has not been delivered than that amount is considered deferred revenue. Once the product is delivered or the service has been rendered then the money can be considered earned and moved to revenue on the P&L.

Accounts Payable – represents expenses incurred but not yet paid. For example, if you received a product but haven’t paid the invoice then the amount that should be paid is considered an expense on the accrual basis of accounting regardless if any cash was disbursed.

Cash Basis Method of Accounting

The cash basis method of accounting recognizes income when it is received and expenses when they are paid. This means that income is recognized when cash is received and not when it is earned. Likewise, if an expense is incurred it is only recognized when cash is paid.

Accounts Receivable: there is no accounts receivable on the cash basis method of accounting. Likewise, there is no bad debt expense on the cash basis method of accounting.

Prepaid Expenses: there are no prepaid expenses on the cash basis method of accounting. Expenses paid, regardless if they are incurred, are typically deductible.

Deferred Revenue: deferred revenue is generally disallowed on the cash basis method of accounting. Cash that is received is considered income regardless if the income is actually earned.

Accounts Payable: accounts payable is generally disallowed on the cash basis method of accounting. Only cash payments of expenses are considered expenses in the taxable year regardless if they are incurred.

First Year Example

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The above balance sheet is on the accrual method of accounting: you can tell because there are accounts receivable and accounts payable. To convert this balance sheet to the cash basis method of accounting you would reverse the accounts receivable and accounts payable into net income. The accounts receivable is increasing sales by $30,0000 and the accounts payable is increasing the expenses by $35,000. This nets out to a $5,000 accrual to cash difference.

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As show above, there are no accounts payable nor accounts receivable and net income is $5,000 higher on the cash basis than the accrual basis.

Second Year Example

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The conversion for the second year gets a little more complicated. As show above, you have two year’s worth of activity. If we just reverse the current year receivables and payables then the beginning retained earnings will be off by $5,000.

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As show above, the retained earnings in $60,000 when it should be $65,000 ($45,000 prior year contributions + $45,000 prior year cash basis net income). That’s because you have prior year accounts receivables and accounts payables on the books. The prior year accounts receivables would increase current year cash sales and the prior year accounts payable would increase the current year expense accounts. The $5,000 net difference would impact beginning retained earnings.

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As show above, there is no accounts payable nor accounts receivables on the books and retained earnings ties from one year to the next. Therefore the accrual to cash conversion is the difference between current year receivables/payables and prior year receivables/payables.

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See the above table as proof – if you take the accrual basis income and net the differences from the payables and receivables then you’ll arrive at the current year cash basis net income.

Conclusion

Converting a set of accrual basis books to cash basis can be difficult. However, with some practice it can be an easy concept to understand. Firstly, you must reconcile beginning cash basis retained earnings, and secondly you need to reverse any payables and receivables that shouldn’t be shown on a cash basis tax return.

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