What if I told you that accounting can actually help you be proactive in managing your business?
I hope your response is “tell me more!”
Here’s a story about a REAL business that I work with – This business has been around for many years, has a lot of employees and dominates its local industry. They don’t have to do any marketing whatsoever, and the phone still rings off the hook. This sounds great, right?
Here’s the catch – they weren’t as profitable as they could have been. Several years ago, the business was printing cash, but over time they saw their margins dwindling. The owner constantly felt stressed out and worried about having enough cash to make payroll, and had to pay himself less and less money. But they couldn’t tell me the reason why they were making less money.
Why is this relevant to accrual accounting, you ask? Read on to see why!
CASH VS ACCRUAL BASIS ACCOUNTING
When I bring up accrual basis accounting, people tend to get very anxious. It sounds scary – a lot of people remember sitting in Accounting 101 in college and hating life. Most business owners don’t want to think about debits and credits, prepaids and accruals.
Cash basis accounting is when you recognize income when you receive cash and expenses when you pay them. Most businesses start off using the cash basis of accounting because it’s the easiest way to do their books. It’s very simple – all you have to worry about is cash in and cash out.
Accrual basis accounting is when you recognize income as it’s earned and expenses when they are incurred. Here are some examples:
Recognizing income as earned – You own a landscaping company and do a very big installation in the month of April. You send a bill for $10,000 to the client at the end of the month, but they don’t pay you until June. Under the cash basis, you recognize income in June when you receive the payment. Under the accrual basis, you recognize income in April when you actually did the work.
Recognizing expenses as incurred – You need a lawyer to help you write some new contracts. The lawyer spends a lot of time working on the project and delivers the drafts to you in January, but you don’t pay the bill until March. Under the cash basis, you recognize the expense in March when you pay the bill. Under the accrual basis, you recognize the expense in January when the work is done.
Inventory/cost of goods sold – You sell custom tank tops. During the month of November your fabric supplier has a big sale, so you stock up on bolts of fabric. But people aren’t buying tank tops because it’s cold out, so you don’t sell your tank tops until May. Under the cash basis, you recognize the expense for the fabric in November when you purchase it. Under the accrual basis, you recognize the expense as cost of goods sold in May when you sell the tank tops.
When you make the switch to accrual basis accounting, you’ll have some new accounts to pay attention to:
Inventory – The value of the products you have on hand and haven’t sold
Prepaid expenses – Expenses that you pay for ahead of time but haven’t incurred (like annual subscriptions or insurance)
Accrued expenses – Expenses that you’ve incurred but haven’t paid for
Deferred revenue – Payments that customers make up front for work that you haven’t done yet (this usually happens under longer-term contracts)
Accounts receivable – Bills you’ve sent to your customers for work that you’ve done that they haven’t paid
HOW CAN ACCRUAL ACCOUNTING HELP YOU MANAGE YOUR BUSINESS?
Back to our real-life customer from earlier. This business has a lot of annual contracts that they bill in equal monthly installments. However, the work is not the same every month – some months, there’s a lot more time and materials that go into the jobs, and some months there’s very little work to be done. But they collect the same amount of money from their customers every month.
The business had historically always used the cash basis of accounting. Rather than recognizing their revenue as earned (in proportion to the time and materials required to do the job), they were recognizing revenue equally every month. In some months their expenses were much higher when compared to their sales due to the increase in time and materials in certain months, and in others their expenses were much lower compared to sales. The owner was constantly trying to do math in his head to figure out if they had enough cash on hand to cover the months with higher expenses and how much they were going to “get back” later on when expenses were lower. They couldn’t figure out what their break-even point was since it looked like revenue and expenses were all over the place from month to month, and they were losing money on a lot of contracts because they weren’t pricing them appropriately.
If they had used the accrual basis instead, they would have recognized more revenue in the months where they did more work. This would have enabled them to match their expenses for the time/materials used on the jobs to the revenue earned from the jobs, which in turn would have resulted in a P&L that reflected the actual state of the business. Then they would have been able to see trends, calculate margins, readily determine their break-even, and price their contracts more accurately.
Making the switch to accrual accounting is like turning the lights on and being able to see your business clearly.
Making the switch to accrual accounting is like turning the lights on and being able to see your business clearly. Your P&L reflects the work you actually did that month, without paying attention to the cash coming in or out. You can see if you’re charging enough for your products or services because your margins are accurate. You can see more accurate trends because you don’t have big pops for large cash outlays. You’re able to make better business decisions because you have better information!
WHO SHOULD USE ACCRUAL ACCOUNTING?
If your business fits into one of these categories, you would probably benefit from making the transition to accrual accounting:
You sell products and maintain inventory on-hand
You have long term contracts or get up front payments from customers
There is a large delay between when you incur expenses and when you pay them
There is a large delay between when you do the work and get paid by your customers
We don’t recommend accrual accounting for business owners who are doing their books themselves. It’s not as DIY-friendly as the cash basis is, so unless you’re an accountant yourself, you are likely to miss something if you do your books using the accrual basis yourself. If your business is smaller and not complex, then the cash basis is probably adequate for your needs.
There are tax considerations for each of the different accounting methods as well, but that’s a topic for another blog post. Just be aware that you generally qualify to use the cash basis to file your tax return if your annual revenue is $25M or less, and there are extra forms to file if you’re going to switch methods for tax purposes.