Converting from Cash Basis to Accrual Basis: A Practical Guide

Most small organizations start off with cash basis accounting — it’s simple, intuitive, and tracks the money as it moves in and out. But as an organization grows, there may come a time when you need to convert to accrual basis.

Why? A bank may require accrual-basis financials for a loan. Or if you’re planning to go public, GAAP compliance is non-negotiable. In either case, you’ll need a set of books that tells a more complete financial story than cash accounting allows.

Step 1: Balance Sheet Conversion

The first step is ensuring that all assets and liabilities at year-end are reflected on the balance sheet. Equity becomes the difference between the two.

⚠️ A word of caution: accountants are used to going in the opposite direction — from accrual to cash — to prepare statements of cash flows. Converting from cash to accrual is like “reversing” the cash flow back into net income.

Typical adjustments include:

• Recognizing noncash expenses such as depreciation and amortization.

• Capitalizing purchases of fixed assets instead of expensing them.

• Recording debt as liabilities.

• Recording debt payments as a reduction of liabilities.

Both beginning and ending balances are required to make these adjustments accurately.

Step 2: Revenue Conversion

Here’s how revenue shifts from cash to accrual:

• Start with cash-basis revenue (from the cash-basis income statement).

• Add ending A/R (revenue earned but not yet collected).

• Subtract beginning A/R (cash collected this period that relates to prior periods).

• Subtract ending unearned revenue (cash collected but not yet earned).

• Add beginning unearned revenue (cash collected in prior periods but earned this period).

The result: accrual-basis revenue.

Step 3: Cost of Goods Sold (COGS)

• Start with cash paid for purchases.

• Add ending A/P (expenses incurred but unpaid).

• Subtract beginning A/P (paid this period but related to last period).

• Subtract ending inventory (purchases not yet sold).

• Add beginning inventory (purchases made last period but sold this period).

The key adjustments here come from changes in accounts payable and inventory.

Step 4: Operating Expenses

• Start with cash paid for operating expenses.

• Add ending accrued liabilities (incurred this period but unpaid).

• Subtract beginning accrued liabilities (paid this period but related to last period).

• Subtract ending prepaid expenses (paid but not yet incurred).

• Add beginning prepaid expenses (paid last period, expensed this period).

The net effect: accrual expenses more accurately reflect the period in which they were incurred.

Quick Rules of Thumb

When converting:

1. Add increases in current assets (e.g., A/R goes up = more revenue under accrual).

2. Subtract decreases in current assets (e.g., A/R goes down = more cash collected, already recognized in cash basis).

3. Add decreases in liabilities (expenses were already recognized in a prior period).

4. Subtract increases in liabilities (expenses incurred but unpaid).

Final Thoughts

Switching from cash to accrual provides a truer picture of financial health. It aligns revenues and expenses to the periods in which they occur, not just when cash changes hands. While the process requires careful adjustments, the payoff is financial statements that can withstand scrutiny — from banks, auditors, and regulators.