It is often accountants are called upon to convert cash basis accounting records to the accrual basis. This post describes how to convert cash basis accounting record into accrual basis.
GAAP requires the use of the accrual basis, yet cash flow information is also important to financial statement readers. On other hand, many smaller companies still use the cash basis of accounting, where revenues are recorded when cash is received and expenses are recorded when cash is paid (except for purchases of fixed assets, which are capitalized and depreciated).
When making journal entries to adjust from the cash basis to the accrual basis, it is important to identify two types of amounts: the current balance in the given account (cash basis) and the correct balance in the account (accrual basis). The journal entries must adjust the account balances from the current amounts to the correct amounts.
It is also important to understand relationships between balance sheet accounts and income statement accounts.
When adjusting a balance sheet account from the cash basis to the accrual basis, the other half of the entry will generally be to the related income statement account. Thus, when adjusting accounts receivable, the related account is sales; for accounts payable, purchases; for prepaid rent, rent expense; and so on.
Converting Cash to Accrual Basis
Assume a company adjusts to the accrual basis every 12/31; during the year, they use the cash basis. The 12/31/08 balance in accounts receivable, after adjustment, is $17,000. During 2009, whenever cash is collected, the company debits cash and credits sales. Therefore, the 12/31/09 balance in accounts receivable before adjustment is still $17,000. Suppose the correct 12/31/09 balance in accounts receivable is $28,000.
The necessary journal entry is:
[Debit]. Accounts receivable = $11,000
[credit]. Sales = $11,000
This entry not only corrects the accounts receivable account, but also increases sales since unrecorded receivables means that there are also unrecorded sales. On the other hand, suppose the correct 12/31/09 balance of accounts receivable is $12,500.
The necessary journal entry is:
[Debit]. Sales = 4,500
[Credit]. Accounts receivable = 4,500
Sales is debited because during 2008, $4,500 more cash was collected on account than should be reported as sales. When cash is received on account the transaction is recorded as a credit to sales, not accounts receivable. This overstates the sales account!.
Some problems do not require journal entries, but instead a computation of accrual amounts from cash basis amounts, as in the example below.
12/31/08 12/31/09 2009
Rent payable $4,000 $6,000
Prepaid rent 8,000 4,500
Cash paid for rent $27,000
The rent expense can be computed using either T-accounts or a formula. T-accounts are shown below:
The use of a formula is illustrated next:
Formulas for conversion of various income statement amounts from the cash basis to the accrual basis are summarized in the following metrics:
Formula To Convert Collections From Sales [To] Sales
(a) Ending AR and related sales have not yet been recorded
(b) AR written off reduced AR but did not result in cash collected
(c) Beginning AR was collected and recorded as sale during the period but was sale of the prior period
(d) Beginning unearned revenue was collected and recorded as revenue in the prior period but was earned in the current period
(e) Ending revenue receivable was earned during the period but has not yet been recorded because it has not been collected
(f) Ending unearned revenue was recorded upon collection as revenue but has not yet been earned
(g) Beginning revenue receivable was recorded during the current period upon collection as revenue but was earned last period.
Formula To Convert Payments For Purchases To Cost Of Goods Sol
(h) Beginning inventory was sold during the period
(i) Ending AP and related purchases have not yet been recorded
(j) Ending inventory must be excluded from cost of goods sold
(k) Beginning AP reflects purchases last period which were not paid for or recorded until the current period.
Formula To Convert Payments For Expenses To Operating Expenses
(l) Beginning prepaid expenses were recorded as expenses when paid in a prior period but are expenses of the current period
(m) Ending accrued expenses payable have not yet been recorded
(n) Ending prepaid expenses were recorded as expenses when paid this period but are expenses of future periods
(o) Beginning accrued expenses payable were recorded currently as expenses when paid but are expenses of the prior period
*) Provision must also be made for depreciation expense and similar write-offs and bad debt expense.
Since the accrual-basis numbers can be derived with T-accounts, you should not have to memorize the formulas.