How to Convert Cash Accounting to GAAP Accounting
How to Convert Cash Accounting to GAAP Accounting
Maybe it’s peer pressure making you want to hang with the cool kids on the GAAP side of the accounting fence. Or maybe it’s the taxman. Or your business has outgrown cash accounting, you’re looking to sell, get a loan, or a seemingly endless list of solid reasons to convert to GAAP accounting.
Whatever the case, converting from cash accounting to GAAP accounting is a significant step for a company, whether the move is forced upon you or specifically sought out. But for as many doors as a conversion to accrual can open for your business, it doesn’t come without hurdles and the need for a well-informed, organized approach.
Naturally, that is exactly where Embark enters the fray, able to lend enormous value to your journey down the accrual accounting road with our specialized insights and vast, hands-on experience. Use the following best practices and quick tips to help you get started on your conversion from cash accounting to GAAP accounting and, as always, Embark is only a phone call away if you find yourself too deep in the weeds.
Let Your Intentions Guide You
First of all, if we want to get caught up in semantics for a bit, we must say that there’s no such thing as GAAP accounting. GAAP-compliant accounting, absolutely, but you won’t find a separate set of accounting rules devised by the good folks at FASB. The term GAAP accounting is synonymous with accrual accounting, the method approved by FASB and, therefore, most of the financial world. It’s that acceptance by the financial world that determines how thorough and consuming your conversion might be.
To put it another way, if you’re converting to accrual accounting strictly because of a tax requirement, then the process likely won’t be as involved as one that’s prompted by a conversion to qualify for loans, entice investors, or push you towards the eventual sale of your company. The financial world is looking for greater detail, a more thorough approach than just the basics that would appease the IRS. Your intentions with your company should guide how you proceed with your conversion to GAAP accounting which, at its heart, is essentially a data collection exercise. Use a few considerations to determine how exhaustive that exercise should be for you and your company.
- If an early goal is to sell your company or attract investment money, GAAP financials driven by accrual accounting are a necessity. The earlier you convert to accrual, the better. Converting from cash accounting once complex business transactions have already occurred makes the move to accrual that much more complicated and consuming.
- Copy all of your statements before making any adjustments in your system in case you are ever audited or need to reference them.
- After you convert, your GAAP books will be different from your tax books, but you file according to your tax accounting. Be prepared to maintain two different sets of books, something very different than what cash accounting requires.
- Is your data a mess? Do you have boxes of random receipts sitting in an empty office somewhere? If so, perhaps converting to accrual should be a goal for the future. Attempting to convert to GAAP accounting with messy data is a recipe for stress and insomnia. In cases where the data is in bad enough shape, you won’t even be able to convert from cash to accrual retrospectively. Instead, you might have to stick with cash as the official and start creating monthly accrual financials.
- Many cash-based companies operate with a lack of consideration on certain transactions, for instance, handing out equity like it's snack-sized candy bars on Halloween. Work with an accountant to see what the impact of such actions will be once you convert.
- The actual conversion process requires specific knowledge of GAAP accounting. If you do not have a team in place that is capable of properly performing the conversion, bring in outside help.
General Pearls of Wisdom
While it's true that every company is different and will therefore have a unique conversion experience, that doesn't mean that every move from cash to accrual accounting is singular and without compare. Take note of a few general areas that are common when a company converts from cash accounting to GAAP accounting. Granted, all of them won't apply to every business, but it's still a good idea to have a solid foundation of knowledge established before wading into the accrual accounting waters.
- Under cash accounting, recognition occurs upon receipt of payment. Under accrual accounting, recognition occurs whenever you've completed your responsibilities to the client/customer, regardless of when you receive payment.
- It’s essential you record monthly accrual, deferral, and other adjusting entries before issuing monthly financial statements to stay on the good side of the GAAP guidelines.
- Be mindful of the useful life of a fixed asset and understand the many different ways the tax code allows you to depreciate assets.
- Payroll under accrual accounting carries new liabilities. Accrued balances in PTO and sick time, as well as salary that crosses over between pay periods, are all liabilities that you must accrue.
- The regulatory environment you're in will affect what type of accruals you have to make, including workers comp taxes, fees related to sales tax, property tax, amongst others.
- Prepaid expenses for a good or service that will be used in a future period need to be capitalized. Insurance is the most common of these, but also be aware of prepaid conferences, advertising, or membership/association fees.
- GAAP requires straight-line rent rather than the simple monthly payments typical under cash accounting. Use a straight-line rent calculator to determine what to record including any lease escalations.
- Debt will have some accrued interest. Also, pay attention to how you record any debt payments since many companies incorrectly expense the entire payment amount rather than applying part of it to the balance of the loan and expensing the interest portion
- You must accrue off-balance sheet liabilities or, put another way, anything that is an agreement for future obligations. For example, free rent for the first few months of a new lease is only free on the paperwork you sign. In your books, you must still expense the straight-line rent for those months, adjusted to accommodate the “free” months. The most common example of these liabilities is your accounts payable, where a liability is created if payment is not made when you incur an expense.
- Accounts receivable works in the same manner as accounts payable from an accrual perspective, so when you fulfill your obligation by delivering a good or providing a service, revenue is recognized at delivery, and the receivable is recorded. If the customer doesn't pay at that time, you still have an asset in your AR to show for it.
Obviously, this is not an exhaustive list but just a handful of the most common things to keep in mind as you go from cash accounting to accrual accounting. To reiterate a previous point, the stakes are very high when converting, so be certain you have access to sufficient experience and knowledge to undertake the conversion successfully. If not, seek outside help before you start and save yourself an awful lot of time and heartache down the road. Of course, Embark will be here to provide guidance and insight along the way.