How to Change From Cash Basis to Accrual Basis for Recording Purposes
The cash-basis method of accounting records financial transactions when an exchange of cash is involved. While this method is usually used by businesses that deal mostly in cash, it is not recommended as an accounting method by U.S. accounting guidelines, known as generally accepted accounting principles, or GAAP. The GAAP accounting method of choice is the accrual basis. Accrual-basis accounting records revenues when earned and expenses when incurred, resulting in a match of current revenues with current expenses. This change from cash-basis to accrual-basis accounting is considered a correction of an error, due to the switch from a non-GAAP to a GAAP method, and its effect is disclosed as a prior period adjustment.
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Instructions
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Determine whether comparative or non-comparative financial statements are presented. Comparative financial statements are side-by-side financials that present information for two or more years; non-comparative statements omit this information. The type of financial statements presented dictate whether the amount of the error correction of the change from cash to the accrual method is adjusted to beginning retained earnings balance for the period of the correction or the earliest period presented.
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Calculate the error correction adjustment, or the amount by which net income is overstated or understated due to the correction, which is the prior period adjustment. Determine this amount by taking the revenue earned and not collected -- which is undisclosed under the cash basis method -- and subtract any expenses incurred but not paid. The net amount will be an understatement if earned revenues exceeded incurred expenses, and it is added to retained earnings. The net amount is an overstatement if earned revenues are less than incurred expenses, and it is subtracted from retained earnings.
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Take the prior period adjustment and adjust the beginning retained earnings balance of the period presented, if non-comparative financial statements are presented. Add or subtract from the adjustment any applicable income tax effects.
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Take the prior period adjustment and adjust the beginning retained earnings balance of the period with the error, if comparative financial statements and the period of the error are presented. If the period of the error is not presented but comparative financial statements are, adjust the beginning retained earnings balance of the earliest period presented. Add or subtract from the adjustment any applicable income tax effects.
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Record revenues when earned and expenses when incurred after the error correction is disclosed on the financial statements. By doing so, you will be following the accrual basis of accounting.
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References
- “Financial: CPA Exam Review”; DeVry/Becker Educational Development Corp.; 2009
- AccountingCoach; Stockholder’s Equity, Entries to the Retained Earnings Account; Harold Averkamp
