How to switch from cash to accrual basis accounting

Business owners are many times confused about which accounting system to choose or what is the major difference between cash and accrual basis accounting. There are many reasons to be considered before deciding which accounting system or method to prefer or implement in your organization. The below article provides you with a detailed procedure adopted under each accounting system, its differences and benefits. The article also provides detailed steps and process to shift from one accounting system to another. Find out more which accounting method is best for your business.

 

Cash Accounting System

Cash accounting, also known as cash-basis accounting is an accounting method where all the records income and expenses are recorded only if there are a cash inflow and outflow.

Under this system of accounting, the receipts (income) are recorded in the books only once the amount is actually received and expenses are recorded in the only when cash is actually paid out.  The cash accounting system is basically adopted by small businesses because it is simpler and more straightforward. This accounting system provides a clear picture of how much of the company’s money is spent and received and what amount of cash is currently the company has on hand.

The cash accounting system is basically adopted by small businesses because it is simpler and more straightforward. This accounting system provides a clear picture of how much of the company’s money is spent and received and what amount of cash is currently the company has on hand.

The major disadvantage of cash accounting system is that many times the books of accounts don’t necessarily provide a complete picture of the company’s asset and liability.

As the company only records only cash transaction under this account system many times the amounts outstanding to be paid or received are not recorded properly making it difficult to get a complete picture of company’s financial position.

 

 

Accrual basis accounting System:

Accrual accounting is an accounting method wherein all expenses and income are recorded irrespective cash is paid or not. Under this accounting system, all economic events are recognized and recorded at the time in which the transaction occurs rather than when payment is made (or received).

This method allows the current cash inflows/outflows to be combined with future expected cash inflows/outflows to give a more accurate picture of a company’s current financial condition. This accounting system helps you to measures the performance and position of a company by recognizing economic events (past-present and future) regardless of when cash transactions occur.

This system of accounting arose out of the need of changing and expanding business needs. In nowadays times there are so many credit (credit transaction simply means transaction without cash based on present events but payment would be paid or received on the later date) buys and sales.

Therefore, it makes sense that every such event should also be reflected in the financial statements during the same reporting period that these transactions occur to provide a correct and more realistic financial picture of the company.

The main difference between accrual and cash basis accounting lies in the timing of when revenue and expenses are recognized. The cash method records all transaction based on actual the cash inflow and outflow whereas accrual accounting system records all transaction based on the event of transaction irrespective whether cash is paid or received.

 

Which Accounting system to apply in your company?

The Internal Revenue Service (IRS)provides an option for a business organization to choose either the accrual accounting method or the cash accounting method to track and report their financial data. Business owners also have the option of using a combination of both accounting systems. The only point is that you must continue to use the same method which was opted the first time.

As per U.S. Code: Title 26 – Subtitle A – Chapter 1 – Subchapter E (Part II) Subpart A – Section 448 states,

Except as otherwise provided in this section, in the case of a—

(1) C corporation,

(2) the partnership which has a C corporation as a partner, or

(3) tax shelter,

taxable income shall not be computed under the cash receipts and disbursements method of accounting.

Exceptions to above rule are as below:

  • Farming business: Farming business is defined as the trade or business of farming (within the meaning of section 263A(e)(4)).

 

  • Qualified personal service corporations: Qualified personal service corporation is defined as any corporation whose core are activities that involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting.

 

  • Entities whose gross total receipts for the year is not more than $10,000,000 (In 2002, Revenue Procedure 2002-28 by the IRS extended the use of the cash method of accounting to certain qualifying small businesses with average annual revenues of between $1million and $10 million. in the previous year.)

 

  • If the entity was not in existence for the entire 3-year period

 

 

How can you change from cash to accrual basis accounting?

 

If a company or individual entrepreneur wants to change their accounting system from the accrual to the cash method of accounting: this change would require a section 481(a) adjustment.

Under the said adjustment, the person must reflect the resulting increases and decreases in the account balances of accounts receivable, accounts payable, and inventory due to the shift of accounting system.

The report of all the adjustment and changes are to be prepared and submitted so as to prevent any duplication or omission of income and expense items.

A negative section 481(a) adjustment decreases taxable income and would be reported in the year of change. A positive section 481(a) adjustment increases taxable income and is generally spread over four years; however, if the positive adjustment is less than $25,000, the company is allowed to recognize the entire amount in the year of change

The company or individual who is opting to change the accounting system then the person need to submit Form 3115 to IRS.

 

Form 3115

The company or individual who is opting to change the accounting system then the person need to submit Form 3115 to IRS.

You can view the form in the below link.

How to file the Form 3115 return?

The Form 3115 must be filed in duplicate for an automatic accounting method change request.

  • The original Form 3115 must be attached to the federal income tax return for the year of the change, including extensions.
  • Another copy of Form 3115 must also be filed with the IRS National Office within the period of the first day of the year of the change and when the original is filed with the federal income tax return for the year of change.Note: In general, a filer if fails to submit Form 3115 within the prescribed timing then he would not be granted an extension of time to file the form except only if unusual and compelling circumstances persist.

Addresses, where the copy needs to be sent, are as below:

Mode of form filed Address
A non-automatic change request An automatic change request (Form 3115 copy)
Delivery by mail Internal Revenue Service Internal Revenue Service
Attn: CC:PA:LPD:DRU 201 West Rivercenter Blvd.
P.O. Box 7604 PIN Team Mail Stop 97
Benjamin Franklin Station Covington, KY 41011-1424
Washington, DC 20044
Delivery by private delivery service Internal Revenue Service Internal Revenue Service
Attn: CC:PA:LPD:DRU 201 West Rivercenter Blvd.
Room 5336 PIN Team Mail Stop 97
1111 Constitution Ave., NW Covington, KY 41011-1424
Washington, DC 20224

 

Below are a few points to be kept in mind while filing the form-3115.

  • When filing Form 3115, you must check whether IRS has issued any newly published guidance which includes revenue procedures, revenue rulings, notices, regulations, or other relevant guidance in the Internal Revenue Bulletin. Please visit irs.gov for all the latest news and updates of the form.

 

  • Unless otherwise provided in published guidance, you must file under the automatic change procedures if you are eligible to request consent to make a change in your method of accounting under the automatic change procedures for the requested year of change. In case you are not permitted to submit an automatic request you can file under the non-automatic change procedures.(Please refer the eligibility and applicability of automatic and non-automatic forms visit irs.gov )

 

  • On a general basis, separate Form 3115 is required to be filed for each change in method of accounting. However, in some cases, you can be permitted to submit single Form 3115 for particular concurrent changes in method of accounting.

 

  • You can refer the below links for information and further instruction file and submit Form 3115 correctly.

 

Revenue Procedures (Rev. Proc.) :

Rev. Proc. 2016-1 – This Rev. Proc. provides specific and additional procedures for requesting a change in method of accounting.

Rev. Proc. 2015-13 -This Rev. Proc. provides the automatic and non-automatic method change procedures which requires consent of the Commissioner to change a method of accounting.

Rev. Proc. 2015-14-  This Rev. Proc. contains a list of accounting method changes that may be eligible to file under the automatic method change procedures.

Rev. Proc. 2015-20  : This Rev. Proc. provides eligibility criteria of the small business taxpayer to make certain tangible property changes without filing Form 3115.

 

While changing the accounting system in your book keeping software the below points are to be noted and followed:

Changing the accounting method at the start of the fiscal year involves the less complicated procedures as compared to changes made in the middle of the year. All the changes required in the expense and income amounts and data must be compensated by manual journal entry to match the system of accounting chosen by the individual.

The below are the generic steps to be adopted in case there are changes from cash to accrual basis accounting method:

 

  • Add accrued expenses: Shifting from cash to accrual means, all expenses of which the company have received the benefit but the amount has not been paid (accrued expense) must be recorded. This means you should accrue for virtually all types of expenses, such as wages earned but unpaid, direct materials received but unpaid, office supplies received but unpaid, etc.

 

  • Subtract cash payments: Subtract cash expenditures made for expenses that should have been recorded in the preceding accounting period. This also means reducing the beginning retained earnings balance, thereby incorporating these expenses into the earlier reporting period.

 

  • Add prepaid expenses: Some cash payments may relate to assets that have not yet been consumed, such as rent deposits. Review expenditures made during the accounting period to see if there are any prepaid expenses, and move the unused portion of these items into an asset account. If you choose to do the same for expenditures made in prior periods, adjust the beginning retained earnings balance to remove the expenses that are now being shifted into a prepaid expenses asset account.

 

  • Add accounts receivable: Record accounts receivable and sales for all billings issued to customers and for which no cash has yet been received from them.

 

  • Subtract cash receipts: Some sales originating in a prior period may have been recorded within the current accounting period based on the receipt of cash in that period. If so, reverse the sale transaction and record it instead as a sale and account receivable in the preceding period. This will require an adjustment to the beginning retained earnings account.

 

  • Subtract customer prepayments: Customers may have paid in advance for their orders, which would have been recorded as sales under the cash basis of accounting. You should instead record them as short-term liabilities until such time as the company has shipped the related goods or provided the indicated services.

 

Note: In case the individual has opted for conversion from accrual to cash accounting method. Then the above steps would be adopted in reverse.

 

How to change the accounting method in Quickbooks

The below is a step-by-step procedure in order to change accounting method in Quickbooks software:

1.      Click the Gear icon and choose Company Settings (or Account and Settings depending on what you see).

2.      Click Company (if you accessed this menu through Account and Settings, click Advanced) from the left menu.

3.      Click the Accounting method section.

4.      From the drop down, choose the accounting method to which you’d like your reports to default, and then click Save.

5.      Click done.

Note:  You can keep overall accounting method for reporting unchanged, but experiment with changing the accounting method only on an individual report here and there to see the difference that change makes in your reporting.

The procedure to change the accounting method for preparing report are as below:

1.      Click Reports to open the Report List page and select the report you’d like to view.

2.      At the top, click the Customize button.

3.      In the new window that opens, go to the General section and then note the Accounting Method selected.

4.      You can click to select a new accounting method.

5.      Make any other necessary customizations and click Run Report.

 

How to change the accounting method in Xero:

 

The below are the steps to be adopted to change the accounting method in Xero accounting software:

  1. Login to your Xero account. Select “Setup”, then select “Business Information” and click on the button “BAS info”.By doing the above step you will find whether the company was setup as reporting on a cash or accrual basis and this is how it will be treated in the conversion.

Please change the accounting method option here and save the changes

Also to change the accounting method and requisite reports setting: Select “Edit”-“Preferences” and click on the button “Tax” and “Reports & Graphs”. You will find whether the company was setup as reporting on a cash or accrual basis.Please change the accounting method option here and save the changes

 

How to change the accounting method in LexisNexis

Please find the attached PDF for your reference. The attached PDF provides the details of steps to be adopted in case of change of accounting method in the accounting software.

 

How to change the accounting method in Wave

Wave software scrapped the policy for conversion from cash to accrual accounting method in October 2014 and since then the software doesn’t allow its user to edit the accounting system.

But if you want to change the accounting system, you can surely connect with the technical support authorities of the software provider.

 

How to change the accounting method in Peachtree

The Peachtree accounting software does not provide an option to change the Accounting Method for the company once it has been created.  Thus in case you need to change the accounting method in the middle of the company life cycle, they can follow the below steps:

  1. Select HELP
  2. Search on Rebuilding a Company for more information.

 

Wrap up: 

When you are deciding the accounting software to be adopted in your organization all the above points are to be considered and discussed.  As nowadays many of the other software has ceased to provide their users with an option to switch the accounting method in the middle of the company life cycle. And more and more software is promoting the idea of accrual accounting system. Accrual accounting is preferable as it provides a complete picture of the financial status of the company along with cash inflow and outflow details.

 

2017-09-12T11:56:58+00:00

About the Author:

Hi, I am Tarannum. I am CA and working in accounting for 10 years. You can subscribe to my blog or join us on facebook.