Converting from accrual to cash basis accounting can make it look like you've earned less money than you actually have, at least in the short term. The accrual accounting system counts each transaction when it is made, regardless of when you get paid for your work or when you pay for materials or services. The cash system counts each transaction when money changes hands, so sales or purchases that are billed and paid later may not count as part of the current accounting cycle. This delay in reporting requirements can provide short-term tax benefits, putting off the time when some tax is due, which is why most people who make the conversion do it around tax time.
Calculations for Converting From Accrual to Cash Accounting
The difference between accrual and cash is equal to the sums that you have recorded but not yet collected or paid. To convert to the cash system, identify these transactions and subtract them from your totals. Subtract all accrued expenses from your income statement. These include accrued tax liabilities and purchases for which you haven't yet been billed. You don't owe these amounts yet, so they don't belong in your cash accounting system. Also subtract your total accounts receivable amounts from the income on your income statement. You haven't been paid yet for this work, so it doesn't count as income if you're using the cash system. Accounts payable should also be subtracted out because you'll record these sums when you pay them, rather than when you accrued them.
Shifting Entries Between Accounting Periods
If you recorded an amount as a sale during the previous accounting period, a cash basis accounting system requires you to shift the timing of that notation to the period when the invoice was paid rather than the period when the work was done. If customers have prepaid for goods or services, these payments will have been recorded as liabilities in an accrual system, but they count as sales if you're working on a cash basis. Prepayments to suppliers are recorded as prepaid expenses according to the accrual system, but they're simply noted as purchases or expenses during the period when the money changed hands if you're using the cash system.
The Internal Revenue Service doesn't allow every business to report on a cash basis, so make sure your business is actually allowed to change before you update your accounting system. Only smaller businesses with no reported inventory at the end of a fiscal year can report on a cash basis. Your annual revenue must be less than $5 million to use the cash method. If you choose cash basis accounting and you do have inventory to report, you also have the option of reporting it using the accrual system.