Transitioning from Cash Basis to Accrual Accounting
Experienced business leaders know they need accurate information to make the best decisions for their company. Simply put, using a cash basis system for your bookkeeping and accounting leaves you lacking important information to measure your business by.
You may be using a cash basis because it aligns with how you do your taxes, but it does not provide the best data on the overall financial health of your business and it can hamper your ability to forecast and attract investors.
You don’t have to be worried about your taxes. You can keep your management books on an accrual system yet still file your taxes on a cash basis.
Cash Basis Versus Accrual Accounting
In cash basis accounting, income and expenses are recorded only when cash is received or spent, respectively. For example, if your business sold $10,000 in services in December but the payment was not received until January, you would not record the revenue until January under cash basis accounting. This system is straightforward and works well enough for small businesses with few accounting needs, but it can be misleading in any given month.
Accrual accounting is more complex but much more accurate at cut-off points such as months, quarters, or years. It records transactions when they occur, regardless of when the cash is received or spent. This provides a more accurate picture of your business’s financial standing and aligns with Generally Accepted Accounting Principles (GAAP).
Advantages of Accrual Accounting
Overall, accrual accounting allows business owners to acutely define if a company is profitable and how expenses are trending. It matches revenues with the expenses the company incurred to produce them. This offers many advantages:
- A real-time view of finances
- Easier tracking of assets and liabilities
- Visibility into overdue accounts receivable
- Better ability to forecast future profit and cash flows
- Easier budget analysis
Another consideration is attracting investors and lenders. Investors and lenders will generally expect a business to be operating on an accrual basis if they are going to partner with you. The clearer financial data is critical to their assessments of the risks involved in providing you with capital.
Switching from Cash Basis to Accrual Accounting
Switching from cash basis to accrual accounting can be challenging, but it is crucial if you want to have a more accurate picture of your financial situation. Here are some steps that you can follow:
- Evaluate the impact: First, evaluate how the transition will impact your business, and determine if you need to hire a professional to help you with the process. Bringing in a fractional CFO or controller part-time can be a cost-effective way to approach the transition.
- Determine which items are prepaid, to be accrued, or deferred: Identify any prepayments or deferred revenue or expenses in your cash basis system.
- Record opening balances: Next, record the opening balances of all of your new accrual accounts, and their associated impact on income and expenses.
- Update your books regularly: Start updating your books regularly to track income and expenses as soon as they are incurred, regardless of cash flow. This should also include a standard end-of-month book closing process that is well documented. Once this is in place, the data in your month-to-month comparisons will be much more valuable from a forecasting and planning perspective.
While the cash basis appears simple and straightforward, it doesn’t give a detailed picture of the company’s profits and losses during a specific period of time. Accrual accounting is a superior way for leaders to get the information they need to make the best plans for the future.
Gregory R. Smith
Greg Smith is a director and practice lead of the Accounting and Management Outsourcing (AMO) group at Redpath and Company. He provides oversight and direction to each of the accounting, payroll consulting and Fractional CFO/Controller areas within AMO as well as directly providing Fractional CFO services. Greg began his career in the entrepreneurial services group at EY in audit and has been a Controller and CFO in public and private companies for over 20 years. Over that time, he has gained experience in a wide range of industries including manufacturing, services, software/internet/high tech, med tech, and real estate. Greg joined Redpath and Company in 2021.
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