The two basic methods of accounting available to businesses are the accrual basis and the cash basis. The accrual basis of accounting records income when it is both earned and realized or realizable. To be earned, goods or services must have been provided. The realized or realizable concept deals with the collection, or foreseeable collection, of payment for the goods or services that were provided. Expenses are recorded when the related income is recorded under the accrual basis of accounting. The cash basis of accounting records income when it is collected and expenses when they are paid. Many businesses operate under the accrual basis but report their tax returns on the cash basis of accounting. Because of the recording differences, there is a reconciliation process that needs to occur to convert from the accrual basis to cash basis.
Items you will need
- Trial balance worksheet
Review your trial balance. If year-end adjustments are necessary, make the adjustments prior to converting from accrual to cash basis.
Examine the accounts receivable account. Accounts receivable, by nature, is an accrual basis account. Every adjustment that is made to convert the accrual basis trial balance to cash basis will involve both a balance sheet account and an income statement account. To adjust the accounts receivable, calculate the net change in the account during the year. For example, if your opening accounts receivable balance was $100,000 and after year-end adjustments the ending balance was $150,000, you would calculate the following formula: $150,000 - $100,000. The resulting $50,000 represents the cash increase in sales during the year. Do not report accounts receivable on your tax return. Instead, the $50,000 cash increase will be included with the reported sales for the year on a cash basis tax return.
Perform the same calculation for your accounts payable. For example, if your opening accounts payable was $100,000 and ending accounts receivable was $200,000, you would calculate the following formula: $100,000 - $200,000. The resulting negative $100,000 represents the cost of materials, office supplies and other expenses that are accrued before being paid.
Allocate the accrued costs calculated above to the appropriate line items of your income statement. This will report your expenses on the cash basis of accounting by eliminating the accrued expenses reported in accounts payable.
Review other accrual basis accounts on your balance sheet and income statement, and make adjustments similar to the ones made for accounts payable and accounts receivable. For example, if you have a deferred tax liability, calculate the difference between the opening and closing and offset the result against your deferred tax expense.
Certain accrual items are allowed to be represented on cash basis balance sheets. Loans receivable and payable, mortgages payable, and sales tax and payroll taxes payable are commonly shown on cash basis balance sheets.
- DragonImages/iStock/Getty Images