4 MIN READ
When you first started your business, you may have chosen to use cash basis accounting for its simplicity. This method works well for new businesses with minimal transactions.
As your business grows, however, you might consider a switch to accrual basis accounting not just for the benefits and sophistication it offers for understanding the financial health of your business, but also because you simply may be required to once your business grows to a certain size.
(Your state regulations may also require GAAP—Generally Accepted Accounting Principles—for your financial documents, in which case you’d have to use the accrual basis method by default.)
Although accrual basis accounting is more complex than cash basis accounting, the process for switching from the cash basis to the accrual basis method can be broken down into three simple steps, which we’ll outline below.
Differences Between Cash Basis and Accrual Basis Accounting
We’ve written before about the differences between the cash and accrual basis methods of accounting, but here’s a quick refresher:
- Cash basis accounting is a single-entry bookkeeping method that recognizes revenue and expenses when cash is received or expenses are paid. When running a cash basis balance sheet, you will not see accounts receivable or accounts payable. Most small businesses opt to use the cash basis of accounting because it’s easy to maintain and update.
- Accrual basis accounting is the method of recording revenue and expenses when earned. It does not take into account when money is actually received or paid. This type of accounting provides a more realistic idea of income and expenses during a given time period.
How to Switch from Cash Basis to Accrual Basis Accounting
To make the move from cash basis to accrual basis accounting, you’ll need to adjust records to account for incurred income and expenses.
Here’s the three-step process for doing so:
Step One: Add accrued and prepaid expenses
Accrued expenses are benefits you incurred but for which you have not yet paid whereas prepaid expenses are payments that were made to vendors for assets you haven’t yet used.
Example. If you purchase a $500 ticket in April for a flight in September, you would put the expense on your balance sheet as prepaid and then move it over to your P&L (profit and loss statement) in September when the expense is actually used.
Sample 9/1/19 journal entry to move the expense from your balance sheet to your P&L:
Dr. Travel: Airfare $500
Cr. Prepaid Expenses $500
Step Two: Add accounts receivable
Accounts receivable reflects money owed to your business. Add any unpaid client invoices to your books. Once the client has paid you, you will move the invoice to a revenue account.
(Accounts receivable is not recorded in your books when using cash basis accounting.)
Step Three: Subtract unearned revenue
This is money received from a client for work that has not yet been performed.
Example. If you bill out $900 in January for services to be delivered in January, February, and March, your income should be split into $300 for each month; $300 is financial planning income for January and $600 is unearned revenue. Once the $300 of income is earned in February, you would make a journal entry from February moving $300 out of unearned revenue and over to financial planning income on your balance sheet. You will repeat this process in March when the remaining $300 of income is earned.
Sample 2/1/19 journal entry:
Dr. Unearned Revenue $300
Cr. Financial Planning Income $300
How to Do Accrual Basis Accounting Once Your Books Have Been Converted
After you convert your books from cash basis to accrual basis accounting, you will need to maintain them using the accrual basis method.
The most important thing to remember is revenue and expense recognition. Be sure you put any expenses in the month that the expense was actually used and any revenue in the month that is was actually earned.
For example, if you worked with a lawyer in March but you didn’t receive an invoice until May, you will enter the invoice as of March 31. This will allow you to put the expense in the proper month.
If you purchase a year-long subscription, you will include it on your balance sheet and then move over a portion of that expense on a monthly basis. For example, if you have a $120 subscription expense, you would want to expense $10/month for the duration of the subscription.
Sample journal entry
Dr. Dues & Subscriptions $10
Cr. Prepaid expenses $10
Now that we’ve covered a few example of expenses, let’s turn our attention to revenue, or income.
If you bill in arrears, you will enter the portion of the income that is attributable to each month. You would do that by making the following journal entry:
Sample journal entry:
Dr. Earned Income/Revenue $250
Cr. Financial Planning Income or Investment Management Fees $250
When an invoice is created, you will record the transaction as “Earned Revenue” on your balance sheet. Once payment is received, you will apply it to that invoice.
While both cash and accrual accounting have their own advantages and disadvantages, converting your books from cash basis to accrual basis may help provide more insight into the financial position and performance of your business.
Considering a switch from cash basis to accrual basis accounting? We can help.