As I was writing the blog (and related cheat sheet) last week, I realized… knowing what a bunch of accounting terms means is great but it doesn’t help you, as business owners, understand why on earth you should care about ANY of them. So I’m going to write a series of blogs over the next month to show you how knowledge and use of these accounting concepts can bring more time and money home to your family! I’m going to call it “How _____ gets you more time and money”. If you haven’t read the blog translating my top accounting terms you can find it here. Or jump straight to your copy of the full-blown cheat sheet here.
What is accounting method?
To recap the cheat sheet, there are two methods of accounting for business transactions. This is more than just an election on your tax forms (though it IS an election on your tax forms and should be consistent with your actual process). Your accounting method is how you choose to track and view your business transactions.
The first, cash basis accounting, is often used by sole proprietors and small startup businesses that don’t have inventory. It is simple and easy for someone to keep track of without a bookkeeping or accounting background. You record revenue when you get paid and expense when you pay someone else.
The second, accrual basis is required for all public companies in the US and Canada. Instead of basing the transactions on the receipt or payment of cash, accrual basis accounting uses the point in time when the transaction is incurred. For example, revenue would be recorded when you have a purchase order, invoice, or signed contract and expense would be recorded when you receive a bill or sign a contract.
Before anyone gets any bright ideas, there is no accounting method that does not require you to keep your receipts. Sorry! Those pesky papers and emails are still a necessity regardless of this selection.
Why should you care about accounting methods?
The accounting method you choose will impact how you see your financial numbers and the level of detail available. The reliability and availability of financial information will impact how we can use it to maximize your business profits. Business profits are how you get more time and money for yourself. Here are some key differences between each method (and how they impact your ability to know your numbers and grow your business).
|CASH BASIS||ACCRUAL BASIS|
|Easy to Use||X|
|Short Term Cash-on-Hand View||X|
|Detailed Information Limited||X|
|Applicable to Any Business||X|
|Long Term Big Picture View||X|
|Detailed Information Available||X|
Ease of Use and Application
The cash basis method of accounting is known for its simplicity and how easy it is to use. You don’t have to be an accountant to know how much money you received and spent in your business. This also allows many startups to save money by tracking their own transactions rather than paying a bookkeeper or accountant.
Not every business can use the cash basis though. You have to use the accrual basis method of accounting if you hold inventory, sell products or services on credit (customers don’t pay right away), or have revenue in excess of IRS requirements. Let’s be fair, the IRS revenue requirements are pretty high ($25 million) and probably won’t impact anyone reading this but the inventory component and ability to offer sales on credit DOES impact many businesses.
Even if your business does not have inventory right away or offer sales on credit yet…you might want the ability to do so in the future. If you select the cash basis method of accounting, you will have to convert to accrual basis. Conversion requires IRS request/approval and adjustments to your accounting records that can cost time and/or money.
Make sure to weigh the current cost savings/ease of cash basis against the cost of potentially converting to accrual basis in the future.
The timeline for recording a transaction can be very different between cash and accrual basis. This difference creates unique views of your business numbers. Just like it sounds, using the cash basis is going to provide a cash-on-hand view of your business. It’s important to know what cash you have available…but there’s so much more to running a business than the availability of cash.
What about the costs associated with generating that cash? Or the ability to continue running the business for months or years into the future?
Accrual basis was designed to provide a more accurate picture of your business. There’s a reason it’s required for public companies and has a whole board of accountants dedicated to ensuring the accounting principles provide clear and reliable information. Accrual basis provides a view of your business VALUE (not just cash) and how that value changes over time.
Cash basis provides a short-term (though potentially flawed) view of your cash-on-hand for business purposes. Accrual basis allows you to take a long-term view of your entire business.
Level of Detail/Data Available
Now that I’ve talked about the ease and view of both accounting methods, it almost goes without saying that accrual basis is going to provide more detail and data for review. It is more complicated, bigger picture, and long-term…of course, it has more data. This reason, more than any other, is why you should care about the selection of accounting method.
As I’ve said before, cash basis focuses on cash. There isn’t a lot of detail or data available in cash basis accounting to analyze and review. However, accrual basis allows us to compare apples to apples and create financial ratios and comparisons that can be consistently reviewed. It allows us to see the impact time has on your business revenues and expenses so we can understand them and forecast them into the future.
Accrual basis gives us consistent and comparable data that we can build on.
So which accounting method should you choose?
That’s completely up to you. There are reasons cash basis exists as an option. A new business, without inventory, that’s focused on getting started rather than growing is likely to opt for cash basis. However, the clients I work with are trying to scale and grow their business. It may not hit $25 million but who knows! They recognize the savings from doing their own books is short-lived and potentially costs more in the long term. These business owners are learning to rely on bank accounts and understandable reports to know where their cash stands day to day. They know how important the big picture is and want….no they NEED… to have access to detailed data to make their best business decisions and maximize the time and money they get to spend at home. For these reasons, I will always recommend my clients use an accrual basis method of accounting. If this sounds like you but you’re currently using cash basis, don’t worry! One of the first steps in my onboarding process is to make sure everyone is setup for accrual basis accounting. If you aren’t quite ready for all this, go for cash basis while you figure it out. Either way, I’m here to help when you’re ready!