Accrual to Cash Conversion Explained Simply

What would you say is the backbone of businesses? 

Depending on your perspective, you could choose different aspects, like making a profit or having a loyal customer base. But do you ever stop to think about the importance of knowing how to handle and process your business’s financial transactions?

Accounting is one of the most fundamental parts of business operations, there can’t be a company running without accounting, it’s as simple as that. 

So how can you understand accounting better? Well, starting with its two main methods, accrual and cash accounting is the smartest choice. 

Learning how to adjust from accrual to cash accounting is equally important. 

So why not learn more about it?

What’s Accrual Accounting?

If we were to explain accrual accounting in simple terms, we could say that this accounting method records revenues and expenses when they happen, regardless of when cash is exchanged. For example, if your company provided a service or registered a big sale this month, but the payment will come still in the next month, and you choose to use accrual accounting, you would need to register the revenue as part of this month’s transactions. The same goes for liabilities. If they happen, they go to the books of the current period. 

What’s Cash Accounting?

Cash accounting, on the other hand, operates differently, it records transactions only when money is earned or spent. So in the same example above, the revenue would be registered on the month, your business receives the money. 

Accrual Accounting to Cash Accounting

While accrual accounting and cash accounting are two very much valid methods of handling your transactions, more often than not businesses prefer to stick with accrual accounting as it provides a full picture of your company’s current financial status.  Yet, there are some circumstances where you might need to keep things simpler and switch to cash accounting 

Key Aspects of Accrual Accounting 

Revenue recognition

You recognize income when it is earned, not necessarily when cash is received. 

Expense matching:

Probably this is one of the main features of accrual accounting. Expenses are recorded when they are incurred, matching them with the revenue they help generate.

Accurate financial picture

Just like we mentioned above, usually accrual accounting is praised for its accuracy. As it gives your company a more complete view of your financial health since it accounts for all transactions.

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Key Aspects of Cash Accounting

Simplicity: 

If there’s a reason why choose cash accounting it’s because of its simplicity. This method it's easy to understand and manage since it only tracks cash transactions.

Real-time insights

You always have a clear view of your available cash, something that comes useful with budgeting and planning.

Ideal for small businesses

Fewer records to maintain make it easier for small businesses to manage their accounts without needing extensive accounting knowledge.

Benefits of Cash Accounting

Less complexity

Yes, we are saying it again, this is less complicated than accrual accounting. You only need to track the cash you receive and the cash you spend.

Better forecasting

Given that cash accounting only recognizes income when it’s actually received, you minimize the risk of overstating your financial position. This accuracy can help you avoid financial miscalculations.

Simpler for reporting

For many small businesses, cash accounting is also advantageous for tax preparation. You report income only when you receive cash and expenses when you pay them, which  aligns better with cash flow and tax liabilities.

Cash flow

And speaking about cash flow.The cash accounting method is a lot like keeping a cash flow statement. When you’re tracking payments and bills, using cash basis accounting gives you a clear view of how much cash your business really has available

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Areas of Accrual to Cash Adjustment

Accounts receivable

These represent money owed to you for services or goods delivered but not yet paid for. Under accrual accounting, you’ll record these as income. In the case of cash accounting, you’ll need to adjust your income to reflect only what has actually been received in cash during the period.

Accounts payable

Similar to accounts receivable, these are expenses incurred but not yet paid. For accrual accounting, you’ll record these expenses in the period they occur. If you want to make the change to cash accounting, you’ll only register the expenses that have actually been paid during the period, meaning you’ll need to adjust your expenses accordingly.

Accrual to Cash Adjustment 

You could be forgiven if you think that making the adjustment from accrual to cash accounting is a complicated business. But in reality, it’s quite easy, to make the conversion you just have to  divide your company’s accounts into two groups: those you’ll need to remove from your financial statements and those you should add back in. 

Accounts to remove

• Accounts Payable
• Accounts Receivable

Accounts to add

• Advanced Income: Payments you’ve received for services or goods that you haven’t delivered yet.
• Prepaid Expenses: These are costs you’ve paid in advance for future services.

Common formulas

Cash sales

Cash Sales = Beginning Balance of Accounts Receivables + Sales Revenue – Ending Balance of Accounts Receivables.

Cash payment for expenses:

Cash Payment for Expenses = Ending Balance for Prepaid Expenses + Expenses in the Income Statement + Beginning Balance for Accrued Expenses – Beginning Balance for Prepaid Expenses – Ending Balance of Accrued Expenses.

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How to Convert Accrual to Cash Adjustments

Accrued expenses adjustment

When you're shifting from accrual to cash accounting, it’s important to subtract accrued expenses from your financial statements. If you can’t back up an accrued expense with a supplier invoice, just reverse it in your records. You can easily find this info in the accrued liabilities section of your balance sheet. Quite simple isn’t it? 

Accounts receivable adjustment

Another important point is this one,  as we have seen AR is a fundamental part of any accounting book so you’ll also want to adjust accounts receivable during this transition. In the case that your company receives the payment for sales after the reporting period ends, make sure to write off any outstanding accounts receivable. This keeps your records accurate and reflects the actual cash you have on hand.

Accounts payable adjustment

And if we are mentioning accounts receivable then we are also mentioning its counterpart. Accounts Payable. The reason? You are going to need to adjust AP as well in your financial statements. Remember that under the cash accounting method, your statements should only show transactions where cash has been paid during the reporting period. So this means including only the costs that were settled in cash during that specific time.

Prior period sales adjustments

At the end of the previous reporting period, gather all sales made under the accrual accounting method. If you receive cash for these sales after the period ends, shift them back to when the payment is due. Since these cash payments are still outstanding, you’ll need to make adjustments along with your current period sales.

Customer prepayment adjustment

Here’s the thing with the accrual method, if your clients prepay for orders, you might count those as revenue when the order is completed. However, in cash accounting, you should record these sales in the period when you actually receive the cash. Something that’s beneficial because it helps you accurately reflect your orders based on real cash flow.

Supplier prepayment adjustment

Last not but least, bear in mind that you must  adjust prepaid expenses similarly to how you handle customer prepayments. When using the accrual method, these costs are treated as current liabilities. Now, you’ll reclassify any prepaid expenses as actual cash outflows to fit the cash accounting approach.

Final thoughts

Understanding accrual to cash adjustments is quite necessary for more precise financial reporting. By familiarizing yourself with the main areas and steps involved, you’ll be better equipped to manage your finances effectively. It may take some time to get used to, but with practice, these adjustments will become second nature.

Remember, maintaining clarity in your financial records is key to having an accurate picture of your company’s financial health. 

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