A growing company often keeps books on the cash basis because that is how it pays tax and how the owner thinks about money. An audit, a review or a lender's covenants usually require accrual-basis statements. The conversion is a set of entries that record what the business earned and owed even though cash had not moved. The conversion is simple to describe and easy to do badly, usually because of the opening balances. This article sets out the steps. For the comparison of methods, see cash vs accrual accounting.
The two methods
Publication 538 describes the difference. Under the cash method, a taxpayer generally reports income in the year it is received and deducts expenses in the year they are paid. Under the accrual method, income and deductions follow when they are earned or incurred. The SBA describes the accrual method as putting transactions on the books immediately upon completing the sale, while the cash method records it only once payment is received, and notes that GAAP is the standard the accrual method follows.
Book basis and tax basis are separate decisions
A client can keep accrual books for the financial statements and use the cash method on its tax return if it qualifies. Publication 538 explains that C corporations and partnerships with a C corporation partner can use the cash method only if they meet the gross receipts test (S corporations are not subject to that restriction). Under section 448(c), the test uses average annual gross receipts for the three prior tax years. Publication 538 states the base limit as $26 million, indexed for inflation, and the indexed limit is $31 million for 2025 and $32 million for 2026 (IRS Rev. Proc. 2025-32). Check the indexed amount for the year in question before relying on it. An entity that fails the test must change to the accrual method and request the change on Form 3115. Converting the books does not change the tax method, and changing the tax method requires the accounting method change procedures. See Form 3115 change in accounting method.
The conversion adjustments
Start from the cash-basis trial balance and layer these adjustments, each supported by a schedule.
1. Accounts receivable
Revenue earned and not yet collected. For each period, list invoices issued and unpaid, plus work performed and not yet billed. Record receivables and revenue. If the client does not invoice, build the list from contracts, delivery records or time records.
2. Accounts payable and accrued expenses
Expenses incurred and not yet paid. Use vendor invoices received after period end, unbilled services, accrued payroll, bonuses, interest and utilities. The search for unrecorded liabilities is the best test: see search for unrecorded liabilities and accrued expenses.
3. Prepaid expenses
Payments for future periods, such as insurance and annual software. Record an asset and expense it over the coverage period.
4. Deferred revenue
Cash received before the service or delivery. Record a liability and release it as the obligation is satisfied. See deferred revenue schedule and ASC 606.
5. Inventory
Cash-basis books often expense purchases. Count inventory at period end, cost it under a consistent method and record the asset. See inventory costing.
6. Fixed assets and depreciation
If purchases were expensed, capitalize those above the policy threshold and depreciate. Book depreciation may differ from tax depreciation. See chart of accounts design and de minimis safe harbor and capitalization policy.
7. Debt
Record loans, accrued interest and current portions.
8. Allowance and other estimates
Record an allowance for credit losses on the receivables. See ASC 326 trade receivables.
The opening balance problem
An audit covers the current period and, for comparative statements, the prior one. Converting only the current year leaves an opening balance sheet that is still cash basis, and the first-year entries will not roll correctly. The fix is to convert as of the beginning of the earliest period presented, and then each period after it:
- Prepare the conversion entries as of the opening date.
- Record the offset to retained earnings or equity, since income that was earned in the past and collected later belongs to prior periods.
- In each following period, reverse the prior period's accruals and record the new ones, or record only the net change.
- Check that the accrual balances in each closing balance sheet agree to schedules.
For the audit side, see first-year audits and opening balances. If the client's statements for the prior period were issued on the cash basis, a change in basis requires disclosure. See change in accounting principle vs estimate.
Support the auditor will want
- Aged receivables list and the subsequent cash receipts.
- Subsequent disbursements testing. See subsequent disbursements testing.
- Payroll registers and bonus calculations.
- Contracts for deferred revenue and the release schedule.
- Inventory count sheets and costing.
- Insurance and prepaid agreements.
- Loan statements.
Process going forward
A conversion done once is wasted if the client reverts to cash entries. Set up a monthly accrual routine: invoice or bill on the accrual date, record bills when received, accrue payroll and review prepaid amortization. See month-end close process checklist.
FAQ
Must the tax return follow the books?
No. A qualifying entity can keep accrual books and use the cash method for tax, subject to the rules in Publication 538.
Where do prior-period accruals go?
Into opening retained earnings or equity at the opening date, with schedules to support each.
Is a review or audit possible on cash-basis statements?
Yes, if the framework is acceptable and disclosed. See cash and tax-basis financial statements.
CORAA prepares ready-to-review audit files for US CPA firms; see /us.
Sources
- IRS, Publication 538, Accounting Periods and Methods: https://www.irs.gov/publications/p538
- IRS, Rev. Proc. 2025-32 (2026 inflation adjustments, section 448(c) limit): https://www.irs.gov/pub/irs-drop/rp-25-32.pdf
- SBA, Manage your finances: https://www.sba.gov/business-guide/manage-your-business/manage-your-finances
- Taxpayer Advocate Service, Small businesses: understand new research expense rules and a July 6 filing deadline: https://www.taxpayeradvocate.irs.gov/news/tax-tips/small-businesses-understand-new-research-expense-rules-and-a-july-6-filing-deadline/2026/06
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