Cash-based accounting is a logical way for most companies to begin their accounting lives. But many choose to switch to accrual-based accounts as their revenue and business grows. Accrual accounting enables you to plan for the future by gaining a more accurate picture of the present, and thus often fits into the modus operandi of large commercial concerns with vast operational procedures taking place.
While cash-based systems are simpler, and ideal for businesses with few transactions, accrual accounting offers several advantages which become compelling as companies expand their operations.
Difference Between Cash and Accrual
There is a fundamental difference between cash and accrual accounting. In cash-based accounting, revenue is recorded when cash is received, and expenses are logged when cash goes out of the business. Whereas in an accrual accounting approach, revenue is recorded when earned, and expenses are taken into consideration when they are incurred. Accrual is thus based on real-world conditions, rather than cash flow.
Why Switch From Cash to Accrual?
Accrual accounting is becoming increasingly popular, as it offers several advantages over a cash-based system. The most obvious of these is that it offers a more faithful representation of the actual circumstances of a company, as a more immediate impression of transactions is registered.
This means that businesses can more accurately gauge their performance from accrual accounts figures, allowing for better planning as businesses accrue for recording spend as it occurs. And this effect is only magnified as companies get larger when the increased amount of business and the sheer number of transactions coming in and out of the business mean that delaying an overall financial picture can lead to false impressions forming.
Additionally, accrual accounting is compliant with generally accepted accounting principles (GAAP). This acronym refers to commonly accepted standards of financial reporting and applies across multiple nations. It is therefore advantageous to get in line with GAAP, even though slightly different rules apply in various territories. The potential of auditing for VCs, evaluation, or acquisitions means that getting accruals correct, and end of the month closes on time, is crucial.
How to Switch from Cash to Accrual
Switching from cash to accrual accounting is not completely straightforward, though. There is an administrative process involved, which can sometimes dissuade smaller businesses who are intimidated by a bureaucratic headache. But achieving this accountancy shift should by no means be considered an insoluble problem.
Preparing for the Switch
Before making the switch from cash to accrual, it is first necessary to convert your books to reflect the new accrual method. It is also important to complete and file any appropriate paperwork with the IRS, or whatever your local tax authority may be.
Steps to be Taken
Once this has been completed then you’re ready to make the cash to accrual switch. This involves six separate steps.
- Add accrued expenses
- Subtract cash payments
- Add prepaid expenses
- Add accounts receivable
- Subtract cash receipts
- Subtract customer prepayments
Add Accrued Expenses
Firstly, add in all expenses from which the company has benefited, but has yet to pay any supplier or employee. Virtually all expenses should be taken into consideration, regardless of whether they’ve been paid for yet or not.
Subtract Cash Payments
This step of the process primarily involves subtracting any cash expenditures made that were not taken into consideration in the previous accounting period. It is also necessary at this stage to reduce the beginning retained earnings balance. Retained earnings are the profits that a company has earned to date, so by making this adjustment the expenses are incorporated into the earlier accounting period.
Add Prepaid Expenses
Some cash payments that a business has made may refer to assets yet to be consumed. Any deposit for an item that has yet to be settled would be a good example of this. Reviewing expenses can help identify these prepaid expenses, and enable the unpaid portions to be shifted into an asset account.
Add Accounts Receivable
This step simply involves recording any sales and all billing that has been issued to clients, and for which payment has yet to be received.
Subtract Cash Receipts
Sales originating in a prior accounting period can often ultimately be recorded in the current period, due to the later receipt of cash. If this is the case, then the transaction should be switched and recorded as a sale and account receivable in the preceding period. Adjustments should also be made to the retained earnings account.
Subtract Customer Prepayments
Finally, when customers have paid upfront for orders, this is recorded as sales in a cash-based system. But such transactions should be altered to short-term liabilities in the accrual accounting method until the goods or services have actually been provided.
Lack of Technological Tools – There is no doubt that switching from cash-based to accrual-based accountancy is tricky, and it is certainly possible to encounter difficulties. One common issue is that accountancy software configured for cash-based accounting will not be automatically prepared to deal with the new accrual approach. Often this requires conversion adjustments to be made manually.
Disorganized/Missing Documentation – It is also quite easy to overlook some transactions during the switch. In order to avoid this, it is essential to examine all transactions from the relevant accounting periods diligently.
Lack of Spend Visibility – And the move from cash-based to accrual accounting requires extensive accounting records. This can often be challenging for small businesses, and can even rule out the possibility completely for some companies, as there is often a lack of spend visibility – which makes accruals very difficult to complete.
Lack of Speed – Furthermore, actually completing the accrual process on time for the end of the month can be an overwhelming logistical task for many small companies. There can often be problems with compliance and visibility with expenses, and pulling all of the relevant information together for a business with minimal resources can often be too much to take on.
So the process of rebooting your accounting with an accrual-based approach is certainly a challenging one. And it’s not one that suits every company. But the advantages of accrual accountancy will continue to attract the most ambitious businesses, despite the pitfalls involved.