How to Convert Your DSO From Cash Basis to Accrual Accounting

Introduction

If you're still relying on cash-based accounting, you might be overlooking critical financial insights that could impact your growth, profitability, enterprise value, and future planning.

Accrual-based accounting isn’t just an upgrade—it’s a game-changer for practices and DSOs aiming to scale, attract investors, and run their business the right way. Some of the benefits include:

1️⃣ Clearer Financial Picture:
2️⃣ Improved Planning & Forecasting
3️⃣ Compliance with GAAP standards
4️⃣ Build trust with investors and creditors

When to make the switch

When organizations are in their infancy, they can get by on cash basis accounting. You might need to consider switching when the following occur:

✅ 1 year or more before a sale
✅ You miss every forecast
✅ You must comply with GAAP
✅ Your revenue level requires it

Matching Principle

The key to accurate accrual accounting is understanding the matching principle. This fundamental accounting concept requires expenses to be recorded in the same accounting period as the revenues they generate. This principle ensures that financial statements provide a more accurate representation of a company's financial performance during a specific period.

How To Make The Switch

WARNING: Switching to accrual requires many complex accounting journal entries, which may require the skills of an experienced accountant, preferably one with dental experience.

I will list the steps needed to make the conversion to accrual. This is organized into a series of journal entries that must be entered into your accounting system or ERP. Most of these entries must be reversed or modified monthly, with new entries taking their place.

These journal entries are crucial for accurately aligning the financial statements with accrual accounting principles.

Step 1. Revenue Recognition

• Revenue is recognized when it is earned, regardless of when the cash is received.

• Add the Accounts Receivable (AR) balance to the balance sheet. You will need to pull this data from your practice management software. You will then use this journal entry to record the transaction:
  Debit: Accounts Receivable
  Credit: Revenue

• Reverse this entry each month and replace it with the new balance at the end of each new month.

Step 2. Accrued Expenses

• Ensure all expenses (excluding payroll) are booked as of their incurrence date, not the date they were paid. Use this journal entry to correct any transactions:
  Debit: Expense
  Credit: Accrued Liabilities (or Accounts Payable)

• Reverse this entry each month and replace it with the new balance at the end of each new month.

Step 3. Payroll Accrual

When payroll is paid after the end of a financial period but relates to work performed in the prior month, it is essential to record an accrual to ensure expenses are matched with the correct accounting period. Follow the steps below to correctly accrue payroll expenses:

• Calculate the total payroll expense for the days worked in the prior month but paid in the following month. Include wages, salaries, overtime, bonuses (if applicable), and employer payroll taxes.

• Create a journal entry to record the payroll accrual:
  Debit: Payroll Expense (Income Statement - Prior Month)
  Credit: Accrued Payroll Liability (Balance Sheet)

• Reverse this entry at the end of each month when you enter the new payroll accrual

Step 4. Prepaid Expenses

• When you pay for something in advance, like insurance coverage for an entire year, that cost must be spread out over the year it is in force. You can use this journal entry when paying for it:
  Debit: Prepaid Expense
  Credit: Cash

• When the prepaid expense is used, use this journal entry to properly expense the prepaid balance equally until the prepaid expense balance is exhausted:
  Debit: Expense
  Credit: Prepaid Expense

Step 5. Unearned Revenue (Deferred Revenue)

• This entry is used to properly codify any payment received before the revenue is earned:
  Debit: Cash
  Credit: Unearned Revenue (liability)

• When the services are provided, the unearned revenue liability is reduced, and revenue will be recognized by using this entry:
  Debit: Unearned Revenue (liability)
  Credit: Revenue

Step 6. Depreciation Expense

• Depreciation spreads the cost of a fixed asset over its useful life to match expense with revenue generated. This entry is done periodically (usually monthly or annually) reflecting the wear and tear, or usage of the asset.
  Debit: Depreciation Expense
  Credit: Accumulated Depreciation

Step 7. Amortization Expense

• Similar to depreciation but for intangible assets (e.g., patents, trademarks).
  Debit: Amortization Expense
  Credit: Accumulated Amortization

Step 8. Interest Expense (Accrued Interest)

• Recognizes interest expense on loans or debt that has accrued but hasn't been paid.
  Debit: Interest Expense
  Credit: Interest Payable

Step 9. Bad Debt Expense (Allowance for Doubtful Accounts)

• Estimates uncollectible accounts receivable, ensuring revenue isn't overstated. When recording the estimates for bad debts:
  Debit: Bad Debt Expense
  Credit: Allowance for Doubtful Accounts

• When the account is determined to be uncollectible. Writing off specific bad debts:
  Debit: Allowance for Doubtful Accounts
  Credit: Accounts Receivable

Step 10. Inventory Adjustments (Periodic Inventory System)

• Adjusts inventory levels to reflect physical counts and match the cost of goods sold to revenue.
  Debit: Cost of Goods Sold
  Credit: Inventory

Conclusion

Is Accrual Accounting complicated? Yes! Does it require a skilled accountant to put it in place and keep it accurate? Yes. Is it with worth it? YES. Not only will you get all of the benefits above, but you will have the confidence you need to move your business forward.

If you have any questions or would like to connect to Ken, you can message him on LinkedIn or schedule a time to meet with him here: https://tidycal.com/accrudent/catch-up-kk