Moving from Cash-Basis to Accrual Accounting

Many small businesses use the cash accounting method. It’s the easiest way to track revenue and expenses and doesn’t require a deep understanding of debits and credits.

However, as your company grows, you might need to change to accrual accounting for tax purposes or simply because you want your financial reports to provide greater insight into your financial position, cash flows, and results of operations.

In this guide, we’ll explain the key differences between cash and accrual accounting, consider the pros and cons of each, and outline the steps for making the transition when you’re ready.

What Is Cash-Basis Accounting?

The cash accounting method is a straightforward way to account for revenues and expenses because you record transactions when cash changes hands. In other words, you recognize revenue when it’s received and record expenses when paid.

The cash-basis accounting method doesn’t use accounts receivable or accounts payable.

Pros of the Cash Accounting Method

• Simplicity. Cash-basis accounting is easy to implement and understand, making it a good option for small businesses and sole proprietorships.
• Cash-flow focused. Since you record income and expenses only when you receive or pay cash, this method provides a direct view of the business’s cash position.
• Tax deferral. Businesses using cash-basis accounting can defer income to the next tax year by simply postponing invoicing or prepaying expenses. This lets you strategically manipulate taxable income to take advantage of lower tax rates.

Cons of the Cash Accounting Method

• Limited financial insight. Cash-basis accounting doesn’t capture the whole financial picture because it excludes outstanding receivables and payables. Your financial statements won’t tell the whole story.
• Incompatibility with GAAP. Cash-basis accounting doesn’t comply with U.S. Generally Accepted Accounting Principles (GAAP). This can limit growth opportunities when dealing with investors or seeking financing.
• Tax limitations. The Internal Revenue Service (IRS) restricts cash-basis accounting for certain businesses, particularly those that earn more than $25 million in annual revenue or hold inventory.

Understanding Accrual Accounting

Accrual accounting records income and expenses when incurred, regardless of when cash changes hands. This accounting method uses accounts receivable and accounts payable, providing a comprehensive view of financial performance.

Pros of the Accrual Accounting Method

• Comprehensive financial picture. By recognizing revenue and expenses when they occur, accrual accounting gives a more accurate representation of a company’s financial health and results of operations.
• Compliance with GAAP. Accrual accounting complies with GAAP, making it a requirement for publicly traded companies and many private businesses.
• Improved financial planning. Accrual basis accounting allows businesses to forecast future income and expenses more accurately, leading to better budgeting and financial planning.

Cons of the Accrual Accounting Method

• Complexity. Accrual accounting requires a deeper understanding of financial principles and a more sophisticated accounting system.
• Cash flow blind spots. Because accrual accounting doesn’t track whenmoneyh is actually received or paid, you may face liquidity issues if you don’t closely track outstanding invoices.
• More intensive recordkeeping. Detailed tracking of receivables and payables makes accrual accounting more time-consuming and costly to maintain.

Why a Business Might Start with Cash-Basis Accounting

Many businesses—particularly small companies—begin with cash-basis accounting due to its simplicity and cost-effectiveness. For businesses with minimal transactions, or those operating in cash-heavy industries, this method works well to track immediate income and expenses. However, as a company grows, financial complexity increases and the limitations of cash-basis accounting become more apparent.

If you want to attract external financing, manage a large amount of inventory, or go public someday, you might find the accrual method better suited to your needs.

Reasons to Transition to Accrual Accounting

Here are a few reasons to transition from cash to accrual basis accounting.

Legal and Regulatory Requirements

You may have to use accrual accounting if you’re in a certain industry or meet a financial threshold.

For example, the IRS generally requires C corporations and partnerships with a C corporation partner to use the accrual method. Its also requires companies that engage in the production, purchase, or sale of merchandise as an income-producing factor to use the accrual method when accounting for purchases and sales of inventory.

However, there is a small business exemption, allowing businesses with less than $25 million in average annual gross receipts over the prior three tax years. These companies can continue to use the cash basis method.

Financing and Investment Needs

Investors and lenders may require GAAP-compliant financial statements, and GAAP financial statements cannot use the cash basis method.

Accurate Financial Reporting

As businesses scale, having accurate financial data becomes essential for decision-making, strategic planning, and stakeholder reporting. Accrual accounting recognizes income and expenses in the periods in which they occur, improving financial transparency and accuracy.

How to Transition from Cash to the Accrual Method of Accounting

To switch accounting methods, you’ll need to notify the IRS and possibly even disclose the change of accounting method in your financial statements.

Below is a step-by-step guide to making the transition.

Step 1: Analyze Financial Data and Software Needs

Before making the switch, review your current accounting processes, software, and personnel capabilities. You may need to invest in new accounting software or work with an accountant who understands the cash to accrual conversion to manage complexity.

Step 2: Adjust Beginning Balances

To start using accrual accounting, adjust your company’s opening balances to reflect accrued income and expenses that have not yet been recorded under cash-basis accounting. This may include adding receivables, payables, and prepaid expenses to your balance sheet.

Step 3: Implement Accrual Adjustments

Once your opening balances are set, you will need to record adjusting entries for all accrued revenue and expenses. This includes recognizing revenue you’ve earned but not yet received and expenses you’ve incurred but not yet paid.

Step 4: Monitor Cash Flow Closely

As you transition to accrual accounting, pay close attention to your company’s cash position. Since accrual accounting does not reflect the timing of cash receipts and payments, your financial reports may show profitability even when cash is tight. Develop accounts receivable collection processes and cash flow management strategies to prevent potential liquidity issues.

Step 5: File an Accounting Method Change with the IRS

If you’re currently using the cash method of accounting, you can generally file an automatic accounting method change by the due date (including extension) of your federal income tax return for the tax year of the change.

File Form 3115 to report the change to the IRS.

Step 6: Disclose the Change in Accounting Methods in Your Financial Statements

You must disclose the change in your method of accounting in the footnotes if you issue GAAP-basis financial statements. You must also restate the prior period figures if you present comparative numbers.

Given the complexity of the transition, we highly recommended working with an experienced advisor who can guide you through the process, ensure compliance with GAAP and the U.S. Tax Code, and help you make the necessary adjustments to your financial records.

Ready to Switch from Cash to the Accrual Method?

Moving from cash-basis to accrual accounting is a big step in the financial evolution of a business. While cash-basis accounting provides simplicity and an immediate view of cash flow, accrual accounting offers a more accurate, GAAP-compliant method that reflects the true financial position of a company.

If you’re ready to take the next step to secure financing or comply with regulatory standards, contact Percipio Business Advisors. We can help you select the right accounting method for your business and follow a strategic process for transitioning to ensure your business is well-positioned for long-term success.

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