Conversion from Cash to Accrual Basis

Conversion from Cash to Accrual Basis

As a church auditor; I find that most ministries prepare their internal financial statements on a cash basis which is most similar to how we all handle our own personal finances. We recognize income when we receive cash and recognize an expense when we actually pay a bill. This makes sense to most ministry leaders since they too are able to relate to how they conduct their own personal finances. I believe that internally prepared financial statements should be useful to the users of the financial statements, so cash basis reporting is perfectly acceptable for internal financial reporting. However; many times ministries will need to provide accrual basis financial statements to external users such as mortgage lenders. I want to try to help you debunk the fear that many people feel when they hear about accrual basis accounting by sharing with you some steps that you can take to convert your financial statements from cash to accrual basis.

The primary difference between cash and accrual basis – as it relates to churches – is when revenue and expenses are recognized (recorded in the financial statements). Cash basis accounting allows recognition/recording of the transaction when cash is physically received and/or released. For instance; revenue is recorded when received and expenses are recorded when payment is made either by cash, check or credit card.

Accrual basis of reporting is distinctly different than cash basis in that revenue and expenses are recognized/recorded when either earned or incurred – not paid. For instance; revenue is recorded when a sale is made rather than when cash is received and expenses are recorded in the period incurred – not paid. In a practical sense; churches and Christian ministries won’t typically have accrual issues with revenue since sales activities are not common. However; expense recognition timing is a significant issue since expenses are frequently incurred in one period and paid in the next. For instance; utilities are typically paid in arrears which means that you pay your utility bill in January for December use.

I want to share with you some practical steps that can be completed in order to more easily convert internally prepared financial statement prepared on a cash basis to an accrual basis. There are two major areas of transactions; 1) balance sheet transactions & 2) profit/loss shifting transactions.

Balance Sheet Transactions

These transactions move expenses and/or revenues from the profit/loss to the balance sheet; which isn’t necessarily an accrual basis activity, but is an essential component for proper reporting purposes. Modifying your chart of accounts (adding/modifying your expense accounts) will be necessary so that these transactions can easily be identified. Some common transactions are:

– Capitalizing equipment & building improvements: whenever equipment, furnishings or improvements to an asset (real estate, vehicle, existing equipment/furnishings) is performed; these transactions are not expensed but rather capitalized. “Capitalizing” is the technical term for removing something from the profit/loss and putting it on the balance sheet. Any expense above $500 (or other predetermined capitalization rate) should be expensed in an account titled “capital expenditures” or “building improvements”. Doing so will allow you to easily identify those transactions when the conversion from cash to accrual basis is needed. At the time of conversion; perform a journal entry to move (capitalize) the expense from the profit/loss and onto the corresponding balance sheet fixed asset account (equipment, building improvements, construction in progress, etc.)

Example of journal entry to capitalize equipment purchase:

Equipment (balance sheet)               1,000 (DR)
Equipment Purchase (Profit/Loss) 1,000 (CR)

– Mortgage & notes payable principal: a portion of each mortgage or other long-term debt payment is applied to either interest or principal. The interest is typically expensed; however the principal portion of your payment is applied towards principal which is a balance sheet item. When the conversion from cash to accrual takes place; you need to identify the outstanding mortgage balance on your mortgage statement or from your lender. This amount will be used to reduce both the mortgage payment expense and outstanding mortgage principal through a journal entry.

Example of journal entry to apply principal payment:

Mortgage (balance sheet)                1,563 (DR)
Mortgage Expense (Profit/Loss)    1,563 (CR)

– Depreciation: a rule of accrual basis accounting is matching up expenses to revenues as they are received over time. This is the guiding principle behind utilizing depreciation since it expenses a fixed asset (real estate, sound equipment, furniture, computers, etc.) over a period of time. Depreciating assets is also utilized as a tax reduction tool by business and generally provides no financial benefit to a church or Christian ministry since they typically do not pay income taxes. However; it is a requirement of accrual basis accounting and should be performed properly. Here is a link to a depreciation schedule sample that you can use to maintain your own depreciation schedule.

Profit/Loss “Shifting” Transactions

These transactions involve recognition timing issues of both revenues and expenses. As I mentioned previous; it is uncommon that a church or Christian ministry will have a recognition timing issue with revenues that result in a receivable. However; it is very common that payables (accounts payable, wages payable, credit cards payable, payroll taxes payable, rent payable, etc.) are created and should be recognized. Some common transactions are:

– Accounts Payable: many churches and Christian ministries do not utilize an accounts payable system mostly because bills are typically entered into the accounting software when they are actually paid – not received. A practical step to generate an accounts payable balance for accrual basis reporting is to “shift” expenses incurred in the current period to the previous period. For instance; any expense paid in the first 5 – 10 days of January 2016 are shifted to December 2015. Here are some example journal entries:

Example of journal entry for accounts payable:

Utilities (Profit/Loss)                      1,235 (DR)
Accounts Payable (Balance Sheet) 1,235 (CR)

Rent Expense (Profit/Loss)            2,500 (DR)
Accounts Payable (Balance Sheet) 2,500 (CR)

These transactions are then paid out of the accounts payable account in the current period, which is as follows:

Accounts Payable (Balance Sheet) 1,235 (DR)
Utilities (Profit/Loss)                       1,235 (CR)

Accounts Payable (Balance Sheet) 2,500 (DR)
Rent Expense (Profit/Loss)             2,500 (CR)

I realize that this may seem like a trivial practice to move an expense into a payable account just to immediately pay it. However; this is a critical component of accrual basis accounting and the absence of payables is one of the most obvious indicators that the financial reporting is based on cash principals rather than accrual.

– Accrued Wages & Payroll Taxes Payable: This is exactly like the accounts payable process that was described above. Wages are typically paid after earned by the employee, which means that wages are also paid after they are incurred (owed) by the employer. For instance; the first paycheck that most employees receive in January is for work performed in December. That means that the employer should have an accrued wages or wages payable account balance as of December 31, 2015. Same goes for payroll taxes since they were collected from wages during December and are not due until January 15, 2016.

With the steps described above; you too can convert your financial statements from cash basis to accrual basis for external reporting purposes.

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