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Convert Your Cash-Basis Books to Accrual at Tax Time

Many small businesses choose to keep their books using the cash method of accounting because it’s simple to follow.

But some businesses have to use the accrual basis for income tax purposes. If this is you, don’t stress out. You don’t need to change how you keep your books or maintain two separate sets of books.

The difference between cash and accrual accounting

The cash basis of accounting is simple because you record revenues when you receive cash and expenses when you pay them.

The accrual basis of accounting is more complicated because you record revenues when they’re earned and expenses when incurred, regardless of when money actually changes hands.

The accrual method of accounting uses several balance sheet accounts to track revenues and expenses that don’t belong on an accrual basis income statement just yet. These include:

  • Accounts receivable. The money your customers owe you for products or services you’ve already delivered.

  • Deferred revenue. Money you’ve collected from customers that you haven’t yet earned.

  • Prepaid expenses. Expenditures you’d paid in advance, such as next month’s rent or an insurance policy that provides several months of coverage.

  • Accounts payable. Amounts you owe to vendors for products or services you’ve purchased on credit.

  • Accrued expenses. Costs you’ve incurred but not yet been billed for, such as utilities or interest on an outstanding loan.

According to the IRS, a business must use an accounting method that clearly reflects its income and expenses. Most choose the cash basis of accounting because it’s simpler.

But some businesses are required to use the accrual basis, such as corporations (other than S corporations) with more than $25 million in average gross receipts for the past three years and those that are inventory-heavy.

According to a 2016 Bench survey of ~1,100 small business owners, roughly 10% were doing cash bookkeeping but accrual filing.

How to adjust cash books for accrual filing

Even if you keep your books on the cash basis, an accountant can use those records to file an accrual tax return. They just need to make a few adjustments to your numbers for that accounting period, including:

  • Adding accrued expenses. Your accountant will increase your expenses for any costs you’ve incurred. For example, if you owe employees a week’s worth of wages that won’t be paid until after year end, they’ll add those accrued wages to your expenses.

  • Adding accounts receivable. If you’ve invoiced customers for work you’ve performed but haven’t been paid for, your accountant will increase revenues by that amount.

  • Removing prepaid expenses. Your accountant will move any prepaid expenses off of the income statement and onto a prepaid expenses account on your balance sheet.

  • Removing deferred revenue. If your customers pay in advance, you may have recorded revenues that you haven’t yet earned. Your accountant will remove that revenue from your income statement, shifting it to a deferred revenue account on your balance sheet.

How Bench can help

Most small business owners don’t want to get into the nitty gritty of selecting an accounting method and making cash to accrual conversions. And you don’t have to.

Bench gives you a team of bookkeepers to handle your bookkeeping and simple accounting software for keeping track of your business finances. We use the cash basis of accounting, but your external CPA can easily use your Bench-provided cash-basis financial statements to file an accrual-basis return. Because your books are in order, the conversion process is easily handled.

Converting cash books for accrual filing

Let’s simplify the cash to accrual conversion with an example.

Say you started your business in 2021 and used the cash basis of accounting. Your year-end income statement shows net income of $100,000.

You meet with your tax advisor and discover that because your business involves a lot of inventory, you need to use the accrual basis on your tax return.

As of December 31, 2021, your cash-basis financial statements includes the following amounts:

  • $6,000 for six months of business liability insurance that you paid in advance
  • $2,000 of cash payments for work you’ll perform in 2022

You also have the following items that aren’t included on your cash basis income statement:

  • $500 for December utilities that will be billed in January
  • $4,000 in employee wages that will be paid on the first payroll in January
  • $1,500 due to a supplier for materials you purchased on credit
  • $10,000 in receivables for invoices you sent to customers for work performed in December

For the cash to accrual conversion, your accountant makes the following calculation:

Description Amount
Net Income (Per Books) $100,000
Plus: Prepaid Insurance $6,000
Less: Deferred Revenue $2,000
Less: Accrued Expenses $4,500
Less: Accounts Payable $1,500
Plus: Accounts Receivable $10,000
Net Income (Per Tax Return) $108,000

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This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. Bench assumes no liability for actions taken in reliance upon the information contained herein.

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