Cash to Accrual Accounting: Guide, Adjustments & Support

Conversion Overview

The cash method of accounting records revenue when cash is received and expenses when cash is paid. Under the accrual method, revenue is recognized when earned, and expenses are recognized when incurred, regardless of when cash changes hands.

Converting from cash to accrual accounting requires these steps:

1. Review existing financial records.
2. Identify required accrual adjustments.
3. Record adjusting journal entries.
4. Publish updated financial statements.
5. File any required IRS accounting method change forms.
6. Update company workflows to support ongoing accrual accounting.

Businesses convert from cash to accrual accounting for several reasons:

• More accurate financial reporting.
• Better budgeting and forecasting.
• Improved analysis through matching revenues and expenses.
• Financial statements preferred by banks, investors, and lenders.
• Compliance with IRS or GAAP reporting requirements.
• Better visibility into receivables and payables.
• Support for business growth, acquisitions, or raising capital.

The scope of the conversion depends on the reason for the change.

• Bank financing, investor financing, or acquisitions often require that one or more prior periods be converted to a consistent accrual basis so lenders and investors can compare financial performance on a comparable basis.
• A change in tax method requires the business to convert, beginning with the applicable tax year, and to comply with IRS accounting method change requirements, including filing Form 3115 when required.

Revenue Recognition

The objective of a cash to accrual conversion is to recognize revenue in the period it is earned rather than when cash is received. Begin by reviewing outstanding customer invoices and all other revenue activity as of the conversion date.

Outstanding Invoices

The first adjustment is for revenue that has been earned but not yet collected. Run an Accounts Receivable Aging report and review all outstanding invoices to verify the goods or services have been provided. The remaining outstanding balances generally become accounts receivable.

Journal Entry:

Dr Accounts Receivable      $25,000
    Cr Revenue                      $25,000

Work Completed But Not Invoiced

Next, review work completed that has not yet been invoiced. This is common for consulting projects and construction jobs. It's work where the performance obligation has already been satisfied.

Journal Entry:

Dr Unbilled Receivable      $10,000
    Cr Revenue                      $10,000

Customer Deposits and Upfront Payments

Finally, review customer deposits or other amounts collected before the related goods or services have been provided. These amounts should not be recognized as revenue until the related performance obligation has been satisfied.

Businesses providing software subscriptions, consulting services, maintenance agreements, or other long-term service contracts should evaluate revenue recognition under ASC 606. Revenue should be recognized as performance obligations are satisfied rather than simply when invoices are issued or cash is received. Multi-year contracts may require monthly or milestone-based revenue recognition.

Journal Entry:

Dr Revenue                  $5,000
    Cr Unearned Revenue             $5,000

Construction companies require additional attention during a cash to accrual conversion. Emphasis should be placed on revenue recognition by reviewing work-in-progress reports and project milestones to determine which portion of the project has been completed and how much revenue should be recognized per period.

Expense Recognition

For expenses, the cash to accrual goal is to recognize expenses in the period they are incurred rather than when cash is paid. Begin by reviewing vendor bills, payroll records, credit card statements, and all other expense activity.

Outstanding Vendor Bills

Run an Accounts Payable Aging report to find expenses incurred but not yet paid. Verify the goods or services have been received and determine the remaining outstanding balance.

Journal Entry

Dr Expense                 $15,000
    Cr Accounts Payable            $15,000

Accrued Expenses

Next, review expenses that have been incurred but not yet billed or paid. Common examples include payroll, commissions, interest expense, and property taxes.

Payroll adjustments are often more complex than other accrual entries because multiple payroll expenses and liabilities may need to be recorded. Many businesses work with a CPA to ensure payroll is accrued accurately during the conversion process.

Journal Entry

Dr Payroll Expense         $8,500
    Cr Accrued Payroll             $8,500

Prepaid Expenses

Finally, review expenses paid in advance such as insurance, rent, software subscriptions, maintenance contracts, and other prepaid services. These costs should generally be recognized over the period they provide a benefit rather than when cash is paid.

Journal Entry

Dr Prepaid Insurance       $9,000
    Cr Insurance Expense           $9,000

Inventory

Inventory is a challenging area in a cash to accrual conversion because purchases may have been expensed immediately under the cash method. The first step would be an inventory count to determine what you have on hand.

Under the cash method, businesses often expense inventory immediately when paid, which artificially inflates the Cost of Goods Sold (COGS) for items still sitting on shelves. This entry effectively backs out the cost of unsold products from your expenses and records them as an asset.

Dr Inventory                     $30,000
    Cr Cost of Goods Sold                $30,000

Inventory Valuation Method

When adopting the accrual accounting method, inventory should be valued using a consistent costing method, such as FIFO or weighted average cost. Before adopting a valuation method, consider the long-term accounting and tax implications, as changes may require additional documentation or IRS approval depending on the circumstances.

Obsolete or Slow-Moving Inventory

Review inventory for damaged or slow-moving items that may no longer be worth their recorded cost. Any inventory reductions should be recorded as part of the conversion to ensure inventory is fairly stated.

Inventory in Transit

Review inventory purchased or shipped near the conversion date to determine whether ownership has transferred. Inventory in transit may need to be included in ending inventory depending on the shipping terms and when title passes to the buyer.

Other Adjustments

Some businesses may need to make additional accounting adjustments depending on their operations and reporting requirements. The following considerations are commonly encountered in more complex cash to accrual conversions.

The Chart of Accounts

A cash to accrual conversion is a good opportunity to review your chart of accounts and reporting structure. As businesses grow, financial reporting often becomes more complex. Before completing the conversion, consider whether your general ledger should be reorganized to better support future reporting, budgeting, and decision-making.

Consider reviewing:

• Revenue and expense account organization.
• Subaccounts for departments, locations, or business units.
• New accounts for prepaid expenses, unearned revenue, and accrued liabilities.
• Fixed asset and depreciation accounts.

Fixed Assets

Review fixed assets to ensure purchases have been properly capitalized rather than expensed. Businesses should also verify depreciation schedules and record any depreciation expenses that have not yet been recorded.

Equity

Owner contributions, distributions, and retained earnings should be reviewed to ensure they properly reflect the adjustments made during the conversion.

Lease Accounting

Businesses with significant operating leases should evaluate whether ASC 842 lease accounting applies. Depending on the circumstances, right-of-use (ROU) assets and lease liabilities may need to be recognized on the balance sheet.

Deferred Income Taxes

If preparing GAAP financial statements, you may need to evaluate deferred tax assets and liabilities under ASC 740.

Business Acquisitions

Companies that have completed acquisitions should also review goodwill and other purchase accounting adjustments as part of the conversion process. Small manufacturers and other growing businesses may acquire competitors or customer lists, making it important to verify goodwill is properly reflected on the balance sheet and that any required amortization or impairment adjustments have been considered.

Review Outputs

Before considering the cash to accrual conversion complete, review the updated financial statements and supporting schedules to ensure all adjustments have been properly recorded. It's good practice to manually test several large account balances to confirm that reports are pulling the correct data from the general ledger. Here are items to review:

• Verify the trial balance is in balance.
• Verify the statement of cash flows ties to the balance sheet.
• Confirm prior periods reconcile if comparative financial statements were prepared.
• Review several significant account balances and journal entries to ensure reports are producing the expected results.

Update Workflows

Once the cash to accrual conversion has been completed, it's important to update your accounting workflows to ensure future financial statements remain accurate. Many businesses create supporting schedules in Excel or within their accounting software to track recurring accrual adjustments and simplify the month-end close process.

Ensure accounting procedures are in place for:

• Revenue recognition and customer contracts.
• Accounts receivable and unbilled revenue.
• Customer deposits and unearned revenue.
• Accounts payable and accrued expenses.
• Prepaid expenses and recurring amortization.
• Fixed assets and depreciation schedules.
• Inventory tracking and cost of goods sold.
• Monthly adjusting journal entries and supporting schedules.

Well-designed accounting workflows help ensure revenue and expenses are recognized in the proper accounting period while reducing manual adjustments and improving the accuracy of future financial reporting.

Compliance

As part of the conversion process, keep the following compliance considerations in mind:

• IRS Form 3115 for accounting method changes, where applicable.
• IRS Form 970 if electing the LIFO inventory method.
• The Section 481(a) Adjustment: When shifting from cash to accrual for tax purposes, you must calculate the cumulative difference in income and expenses from prior years. This adjustment prevents items from being duplicated or entirely omitted from your taxes, and it is usually spread out over four years if it increases taxable income.
• Loan covenants to ensure converted financial statements meet lender reporting requirements.
• Supporting schedules for accruals, depreciation, inventory, prepaid expenses, and other adjusting journal entries.
• Supporting documentation for revenue recognition, including contracts, performance obligations, invoices, and other records supporting the conversion.

Working With a Firm

Converting from cash to accrual accounting involves many steps. An experienced firm can quickly identify required adjustments and prepare supporting schedules.

Working with a CPA also helps establish repeatable accounting workflows for revenue recognition, prepaid expenses, depreciation, inventory, payroll accruals, and other month-end adjustments. Well-designed processes reduce manual work, improve reporting accuracy, and make future accrual-based month-end closes easier.

Excel Complete helps businesses transition from cash to accrual accounting by preparing the required adjusting journal entries, supporting schedules, and financial statements. We also provide compilation services to help position your business for bank financing, investors, acquisitions, and future growth.

Frequently Asked Questions

Below are answers to some of the most common questions businesses have when converting from cash to accrual accounting.

When should a business convert from cash to accrual accounting?

Businesses often convert from cash to accrual accounting when seeking bank financing, raising capital, preparing GAAP financial statements, improving financial reporting, or when required for tax or reporting purposes.

Does changing from cash to accrual accounting require adjusting journal entries?

Yes. Most cash to accrual conversions require adjusting journal entries for accounts receivable, accounts payable, accrued expenses, prepaid expenses, inventory, unearned revenue, depreciation, and other balance sheet accounts depending on the business.

Can QuickBooks automatically convert cash basis accounting to accrual accounting?

QuickBooks can generate accrual-based reports, but adjusting journal entries still need to be prepared to ensure financial statements accurately reflect accrual accounting.