Most financial statements are prepared under the accruals basis of accounting as required by GAAP, however, there are occasions when information is required on a cash receipts and payments basis. In these circumstances the accrual to cash conversion process is used to convert between the two systems.
Under the accruals basis of accounting revenue is recorded when earned and expenses are recorded when incurred. In contrast, under the cash basis of accounting revenue is recorded when cash is received, and expenses are recorded when cash is paid.
This is summarized in the table below.
Accrual to Cash Example
If a business has maintained it’s bookkeeping records on an accruals basis, at the end of the accounting period the balances on each ledger account will reflect revenue earned and expenses incurred during the period.
It should be noted that the calculation of cash receipts and payments is normally done for information purposes only, and that accrual to cash conversion journal entries are not normally posted into the accounting records, unless there is a need to permanently change the basis of accounting.
To calculate cash receipts and payments the business will need to adjust the balances from each revenue and expense account to reflect the accrual to cash conversion.
Accrual to Cash Conversion Formula
In general the following accrual to cash conversion formulas can be used to convert each revenue and expense income statement account from the accrual basis to the cash basis of accounting.
In each formula the terms used have the following meanings.
- AR = Accounts receivable
- AP = Inventory accounts payable
- AE = Accrued expenses payable
- Revenue, expenses, purchases, inventory, and cost of goods sold are on an accruals basis.
Calculating Revenue Cash Receipts
The revenue cash receipts is given by the following accrual to cash conversion formula.
Suppose for example the revenue earned by a business is 7,600 and the balance on the accounts receivable account at the beginning of the year is 9,000, and at the end of the year is 12,000.
The revenue cash receipts for the year is calculated using the formula as follows.
Revenue = 7,600 Beginning accounts receivable = 9,000 Ending accounts receivable = 12,000 Receipts = Revenue + Beginning AR - Ending AR Receipts = 7,600 + 9,000 - 12,000 = 4,600
Cash receipts from sales are lower than the revenue earned due to the increase in accounts receivable of 3,000.
Calculating Expense Cash Payments
The expense cash payments are given by the following accrual to cash conversion formula.
If a business has expenses incurred of 13,200 for the year and the beginning balance on accrued expenses payable is 2,000, and at the end of the year is 5,000, then the expense cash payments can be calculated using the formula as follows.
Expenses = 13,200 Beginning accrued expenses payable = 2,000 Ending accrued expenses payable = 5,000 Payments = Expenses + Beginning AE - Ending AE Payments = 13,200 + 2,000 - 5,000 = 10,200
The expense cash payments are lower than the expenses incurred due to the increase in accrued expenses payable.
Other Useful Accrual to Cash Conversion Formulas
The formulas used above deal with the most frequently encountered situations when converting accruals based revenue and expenses to cash receipts and payments.
The accrual to cash basis conversion formulas below allow for additional complications where the business has for example to deal with unearned revenue, prepaid expenses, and inventory.
In each case the formula shows how to calculate cash receipts and payments using information from an accruals based accounting system.
1. Revenue Accrual to Cash Conversion – Adjusting for Unearned Revenue
2. Revenue Accrual to Cash Conversion – Adjusting for Accounts Receivable Written Off
3. Expenses Accrual to Cash Conversion – Adjusting for Prepayments
4. Purchases Accrual to Cash Conversion
5. Cost of Goods Sold Accrual to Cash Conversion
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.