Your company is acquiring the business of an unincorporated competitor. This business has previously prepared its accounts using the cash basis – how should you bring it into line with standard accruals accounting?
Cash basis of accounting
What is it? Under cash basis accounting transactions are recorded when the cash related to them is paid or received. For example, sales are recorded on receipt of cash, not when the customer is invoiced. Similarly, costs are recorded when payment has been made to the supplier, not when the supplier’s invoice has been received.
New rules. Since April 2013 unincorporated businesses (i.e. sole traders and partnerships but not companies or LLPs) with a turnover of less than £81,000 per year are permitted to prepare their accounts on a cash basis. In fact, once a business is using the cash basis, it can stay using it until turnover is more than £162,000 per year.
Tip. If your company acquires, or is looking to acquire, a business that has been accounting on a cash basis where you, the acquiring business, use the accruals basis, for financial reporting or due diligence purposes, you’ll need to convert the new business’s records to the accruals basis.
Converting to accruals accounting
The accruals basis is used to record sales and expenses in the period that they relate to, irrespective of actual cash flows. To convert from the cash to the accruals basis, you’ll need to take the acquired business’s trial balance at the date of acquisition and follow the steps below.
Step 1. Add in accrued expenses. You will need to identify all purchases/expenses for which the company has received a benefit but has not yet paid the supplier or employee. For example, wages earned but unpaid and materials or office supplies not yet paid for. The journal to add these back is: Dr Expense (P&L), Cr Accruals (B/S).
Step 2. Add in prepaid expenses. Some cash payments made in the period may be for a future period, e.g. rent paid in advance. These can be tricky to identify but the common expenses to review are rent and rates, insurance and subscriptions. Move the unused portion of any prepaid expenses to a prepayments current asset code: Dr Prepayments (B/S), Cr Expense (P&L).
Step 3. Subtract cash payments. It’s likely that the trial balance will include payments for expenses that related to an earlier accounting period. These will need to be subtracted from the expenses shown on the P&L. The journal to do this is: Dr Retained earnings (B/S), Cr Expense (P&L).
Step 4. Add in accounts receivable (debtors). You’ll need to get a list of all unpaid sales invoices and add these into the accounts: Dr Accounts Receivable (B/S), Cr Sales (P&L).
Step 5. Subtract cash receipts. Sales may include cash receipts relating to sales in a prior period. Therefore, you need to reverse the sales transaction in the current period and record it as a sale in the previous period. To do this: Dr Sales (P&L), Cr Retained earnings (B/S).
Step 6. Subtract customer prepayments. Customers that have paid in advance will be included in sales under the cash basis. Therefore, you’ll need to remove these from sales: Dr Sales (P&L), Cr Deferred income liability (B/S).
Tip. As there are a number of adjustments, it will be easier to manage the conversion on a separate spreadsheet.
As the cash basis only records transactions when the cash is paid or received, you need to make adjustments for unpaid sales and expenses and advance receipts and payments. It will be much easier to manage the conversion on a separate spreadsheet.