How to convert cash basis to accrual basis accounting?
It’s a common question from nonprofit accountants and bookkeepers, when their organization is new and growing, and they want to ensure that sound financial accounting practices are in place.
Here we’ll cover the seven main steps to take to make this conversion.
First, however, we need to dig a little deeper into the main reasons for changing and the benefits of being prepared for these changes…
Why go from cash basis to accrual basis accounting?
You cannot underestimate the value of a well-designed general ledger accounting system. Accompanied by a set monthly schedule of procedures, it provides reliable financial statements that give crucial insight into your financial position and financial performance.
When starting out, many nonprofits choose to maintain their accounting system of records on the “cash basis of accounting”.
As you grow larger and more complex, however, it may be necessary to change to the “accrual basis of accounting”. You can find definitions and a discussion of the main differences in this blog post.
Converting from cash to accrual basis may be prompted by one or more of the following:
- A legal requirement, e.g. nonprofits in California with annual revenues exceeding $2 million are generally required to follow the accrual basis.
- A desire to issue audited financial statement in accordance with generally accepted accounting principles (GAAP).
- A desire from your board of directors for more meaningful financial reports when critical decisions need to be made.
What’s involved in making the change?
Converting your accounting system from cash to accrual is not rocket science but it does require some thought and planning.
Doing a “cash to accrual conversion” requires making a series of adjustments in your financial accounting system so that your financial statements (balance sheet, P&L, budget, etc.) present your organization’s assets, liabilities, revenues and expenses in the proper period.
These adjustments, made by your bookkeeper or accountant, are known as “adjusting journal entries” and they fall into two categories:
1. Accruals
Accruals involve taking a transaction where the cash impact is down the road and recording it in the current period’s financial statements because the underlying economic event (i.e. the thing that triggered the transaction) occurred in the current period.
Example: a pledge promised to you in 2018 is not due to be collected until 2019. Under the accrual method of accounting, it should be recorded in the 2018 financial statements.
2. Deferrals
Deferrals are the opposite of accruals. Posting deferrals in your accounting system involves transactions where the cash impact is today but that should not be recorded in the current period’s financial statements.
Example: you pay for your 2019 insurance policies in 2018 (perhaps to receive a payment discount or save money on installment charges). Because the payment to the insurance carrier is not for an expense of the current period, your bookkeeper records a deferral to delay recognition of the expense until 2019.
How to convert cash basis to accrual basis accounting: 7 steps
In a cash-to-accrual conversion, completing the following steps should result in making most, if not all, of the necessary adjusting journal entries.
For organizations that already follow accrual-basis accounting, these steps should already be encapsulated in your monthly and annual accounting checklists.
1. Record accounts receivable
Determine amounts that may have been owed to your organization as of the last day of the year or month (i.e. the balance sheet date) for services already rendered to your clients or customers but not paid to you until after the balance sheet date.
2. Record pledges and grants receivable
Identify grants and contributions that were formally committed to you as of the balance sheet date but not paid to you until later.
3. Identify prepaid expenses
Identify any situations where the organization has paid for the following year’s expenses in the current year (e.g. insurance policies, memberships, etc.) and then defer these expenses appropriately.
4. Identify fixed assets
Identify any significant assets owned by the organization (land, buildings, equipment, vehicles, etc.) and record their cost and accumulated depreciation in the accounting system. Your insurance files and property tax records can assist in this process.
5. Check accounts payable
Identify any situations where expenses may have been incurred in the current accounting period but not paid until after the balance sheet date. The easiest way to do this is to look at the bills that were paid in the few weeks after year-end and identify which ones pertain to the year that just ended.
6. Assess accrued vacation
For organizations that provide paid time off to their employees, liabilities for unused vacation can be significant. For some organizations, this is their most significant liability and it should definitely be reflected in the organization’s financial statements.
7. Assess accrued payroll
If employee pay periods end in one accounting period but workers are paid in the next, it is necessary to accrue the current period’s portion of wages and payroll taxes.
Remember, these general guidelines on how to go about cash-to-accrual conversions are a good start but they should not replace the professional expertise of a qualified bookkeeper or accountant.
