I’ve had a lot of conversations recently around the topic of cash vs. accrual financial statements. This is an incredibly important topic that every business needs to understand. For the most part, every business needs to keep their books on the accrual basis internally. There are 3 main reasons to do this, but first let me give a quick explanation of accrual basis in case you’re unfamiliar.
Almost everyone is familiar with cash basis financials. You record the revenue when the cash comes in and you record the expenses when cash goes out. Simple. However, this isn’t going to give you the clearest picture of your company. Enter accrual basis financials. Under this method, revenue is recorded when earned and expenses are recorded when incurred. Let me explain with a short example.
Let’s say you start a job in early February and complete it by the end of the month. You send the client an invoice for $100,000 on February 28. Back in December you bought $75,000 worth of supplies to complete the job. The client pays the $100,000 in early March for the completed job.
Under the cash method you would have $75,000 of expenses in December and $100,000 of income in March. That is when the cash went out and subsequently came in. Easy.
Under the accrual method the $100,000 of revenue and $75,000 of expenses would both be recognized in February. The revenue was earned in that month and the expenses were used up in that month. This gives you a much better picture of what actually happened, right?
Now that you understand the difference, let’s look at the top 3 reasons to keep your books on the accrual basis. I am going to keep the explanations of each as short and sweet, but I think most will be pretty self-explanatory. However, if there’s an area you want to know more about feel free to shoot me a message anytime for more info.
Comparing your financials month over month can be an incredible tool and very insightful. In order to do this, your books need to be on the accrual basis. Your revenue and expenses need to be in the proper months or this type of analysis simply won’t make sense.
Matching Revenue to Expenses
In the example above, I am sure you can see why matching your revenue and expense is extremely important. If you are keeping your books on the cash basis, many times transactions will be recorded in the wrong period.
Understanding the past can help you predict the future. Obviously this is never perfect but having a clear picture of the history of your business can pay huge dividends. If your revenue and expenses are in the wrong period, this information becomes useless.
I understand that some smaller businesses can get away with keeping their books on the cash basis. However, for most other businesses, there really is no excuse to be keeping your books on the cash basis — it just isn’t as effective. You need to be using your financials to make more informed decisions and cash basis financials simply aren’t the answer. In the past I have touched on the idea of “flying blind” by not using your financials to help you make decisions. If you are keeping your books on the cash basis, this is just another form of “flying blind”.
I want to close this post by making two quick points. First, if you keep your books on the accrual basis, it doesn’t mean you have to file your taxes on the accrual basis. In fact, it makes sense for most people to keep books on the accrual basis and file their taxes on the cash basis. Second, just because you keep your books on the accrual basis, doesn’t mean you can’t see cash basis financials as well. In fact, there is a big benefit to doing this. However, if you keep your books on the cash basis, there is no way of easily converting them onto the accrual basis. The system simply doesn’t work that way.
I hope this post was insightful for you. If you are still keeping your books on the cash basis, I would seriously question why you are doing that. I am not saying that it is necessarily wrong, but I would encourage you to question it. As always, I am here to help if you have questions or want to dig into this topic a bit deeper.