Accrual to Cash
Organizations regulate their financial account statements using either of two accounting bases: cash or accrual. Most businesses use the accrual basis of accounting to comply with Generally Accepted Accounting Principles (GAAP). It became the standard because of its ability to show a more accurate, real-time account of a business’s performance. Despite this, some instances require information on cash receipts and payment basis. This is where accrual to cash conversion processes become relevant.
Before going further, understand the difference between the accrual and cash methods of accounting. Accrual accounting, like mentioned, is more comprehensive. It contains records of expenses paid and money earned, whether or not cash was exchanged. Big corporations benefit more from using this. Some terms of note in accrual accounting are:
- Accounts Receivable – money earned but not yet paid or collected. Products and services with a grace period for payments typically count as accounts receivable.
- Accounts Payable – opposite of accounts receivable, this represents money to-be-spent for an expense. Any goods received that you have yet to pay for fall under accounts payable.
- Deferred Revenue – this is revenue when cash has been collected, but the product or service has not been given out. Stores that accept online payment for delivered goods work with deferred revenues frequently.
- Prepaid Expenses – the amount already paid for services or products yet to be redeemed. Until that time, it counts as a liability on the books. Advanced rent and insurance payments are prime examples of this.
The counterpart of accrual accounting, the cash basis method, only records cash when it is paid and not when it was earned or expended. Again, only when cash exchanges hands will the cash method recognize a transaction. Because of its simplicity, this method is convenient for small businesses because it only notes cash inflow and outflow. The accrual terms mentioned above are not allowed in cash basis accounting. This method disallows prepaying and deferring any amounts.
Although cash basis is more straightforward, it is not as thorough. It becomes obvious here why most companies and the GAAP prefer using accrual accounting as the standard. However, some instances require using the cash method:
- Tax returns
- Reconciling of financial accounts
Note: Reconciliation of accounts is only needed for comparing the company’s cash flow, especially with the bank. Since accrual accounts do not record the date of when money is exchanged the way that banks do, they must do some accrual to cash adjustments to align their records with the bank’s timeline.
Accrual to cash conversion is arguably one of the most complicated concepts in accounting. Conversely, cash to accrual conversion is just also a difficult feat.
Accrual to Cash Example
Given that this is a complicated topic, a sample scenario might be helpful. Here are a few accrual to cash examples:
Example One: The Pear Store is a place that sells gadgets, and they offer payment plans. For a $100 phone, a customer has five months to pay; only their credit detail and contact information is needed for collection.
Cash basis accounting will not consider this $100 as earned; not until it is paid by the fifth month, increment payments will be noted. Accrual basis, however, puts this down as accounts receivable. The item has left their premises, and although the money is not with the store, it is already considered as part of money earned.
Example Two: Bella’s Beauty is an online retailer. A customer orders some makeup pieces from the store, all amounting to $400. The customer chooses the online payment option.
With cash accounting, this will simply be put down as profit for that date. But according to the accrual method, this is deferred revenue. Upon ordering, the payment was promptly given to Bella’s Beauty, but the products have not been delivered. Accrual accounting will record this transaction as deferred until the product is delivered. Then, it will be moved as an official revenue on the P&L (profit and loss statement).
Example Three: Gary is opening a new restaurant in December. He already paid the $40,000 yearly lease for the location; all he needs is new equipment for his operation. He decides to get a loan to reach his goals.
If Gary used cash accounting to keep track, records will show the $40,000 as an expense for December, the same as the loan. Using the accrual method, the expense for the lease will be a prepaid expense and therefore recorded through the whole period. The loan is now an account payable and will be earmarked to be paid in the future.
Accrual to Cash Conversion Formula
Formulas are a constant in accounting, no surprise there. We use it to accurately get the conversion for accrual to cash accounts. In accrual to cash conversion, some variables need to be removed from financial statements, while some need to be added. For removal are accounts payable, accounts receivable, outstanding expenses, and outstanding income. Advance income and advance expenses are added to the statements.
A few steps to follow as a reminder:
- Move prepaid customer accounts. For customer prepayments, accrual accounting writes it down as deferred revenue. When converting into cash basis, transfer prepayments to when the money was paid.
- Move prepaid supplier accounts. If the company prepaid for a service, accrual basis logs it as a prepaid expense. Move it to the paid date when converting to a cash basis.
- Remove accounts receivables. If the cash exchange didn’t happen within the period the statement is for, take it out. Only write down transactions done within the timeframe.
- Remove accounts payable. Do not include expenses paid outside the period.
Other Useful Accrual to Cash Conversion Formulas
Having mentioned how complicated accrual to cash adjustments can be, below are a few more formulas that can help.
Sales Revenue + (Beginning Balance x Accounts Receivable) – (Ending Balance x Accounts Receivable) = Cash Sales
To be written as:
Sales Revenue + BB AR – EB AR = Cash Sales
Payments for business expenses are another variable in financial statements. The formula for converting that would be:
Expenses + (Ending Balance x Prepaid expenses) – (Beginning Balance x Prepaid Expenses) + (Beginning Balance x Accrued Expenses) – (Ending Balance x Accrued Expenses) = Cash Payments for Expenses
To be written as:
Expenses + EB PE – BB PE + BB AE – EB AE = Cash Payments for Expenses
Purchases for inventories are also part of the conversion process, and it uses this formula:
Cost of Goods Sold + (Ending Balance x Merchandise Inventory) – (Beginning Balance x Merchandise Inventory) + (Beginning Balance x Accounts Payable) – (Ending Balance x Accounts Payable) = Cash Payments for Merchandise Inventory
To be written as:
Cost of Goods Sold + EB MI – BB MI + BB AP – EB AP = Cash Payments for MI
Accrual basis accounting is more complex but also more detailed. All transactions, whether money is exchanged or not, are recorded and noted. With this method, a company has a keener look into their financial standing at any given point in time, including their existing liabilities and assets. For big organizations that do multiple simultaneous transactions across scattered periods, accrual is the best bet.
Cash basis accounting is straight to the point and only counts outgoing and incoming cash. Small businesses, especially those only starting, will fare well with cash accounting.
Both accounting methods have their merits, and their usefulness depends on the business’s needs.