Barry, owner of an electrical contracting business, was frowning at the reports on his desk. His eyes narrowed as he looked up at me.
“When we talked a week ago, you told me last month’s income was the best month of the year so far,” he said. “But when I run the reports, it looks like one of my worst months! And that makes sense, because I’ve got overdue bills to vendors and no cash to pay them.”
I asked him a simple question. “Are you looking at cash or accrual reports?”
“Huh?” he asked. “What’s the difference? Isn’t revenue just revenue?”
I shook my head. “Not in your case.”
Why It’s Not Cash Versus Accrual
There are two approaches to tracking financial results: accrual and cash. As a small business owner, you need to understand both, and recognize which one to use when you want to learn something about your business. Bear with me as I venture into some accounting-speak to make this clearer.
Recognize versus realize. Accountants use these two words to describe accounting events, like income and expenses. You realize revenue on the day you receive payment from a customer. You recognize revenue on the day that you provide the service or sell the product to a customer. In some businesses these two events are simultaneous, and in others they aren’t.
Cash and accrual offer us two ways of looking at your business.
Cash basis accounting. This recognizes and realizes cash and revenue at the same time. For example, when you check out at the grocery store, your purchases are recognized as part of that day’s sales. If you pay cash, they are also realized as part of that day’s sales.
Accrual basis accounting. This recognizes revenue now and realizes that same revenue at a later date. In my firm, we provide services throughout the month for a client. At the end of the month, we bill our clients. We recognize the income on the last day of each month. As clients pay us in the next few weeks, we realize that revenue.
That’s just revenue. The same two methods apply for expenses and other transactions in your accounting system.
Why do you care? Like Barry, you will want to use the proper information to understand and address problems and opportunities in your business. Let’s be clear, one method is not better or more accurate than the other. They just focus on different things.
When to Use Accrual Accounting
Answer these two questions:
• Does your business generate receivables? That means you do work today, send out an invoice and get paid down the road. Then accrual reports give you a better understanding of whether or not your business is profitable.
• Do vendors give you a long time to pay? In some industries, it’s common for vendors to get paid in 90 days. Then accrual reports will give you a better understanding of your cash flow today and down the road.
When to Use Cash Accounting
Here are two useful guidelines:
• For tax preparation. All 1040s and most small business income tax returns are prepared on a cash basis. When did the money enter or exit the bank account? That’s what matters to the IRS.
• For paid at time of service. If you provide a service or sell a product and get paid right away, cash basis reports should be fine. In fact, for a business like this, there may not be significant differences between cash and accrual.
Watching the Light Come into Barry’s Eyes
Barry was looking at cash-basis reports, which indeed revealed the prior month as wretched. When we had him run the same report on an accrual basis, his prior month suddenly emerged in its splendor. As we looked at both reports, Barry saw that he had a collections problem, not a revenue problem.
He thanked me and shook my hand as I stood to go. “I was gonna yell at my sales staff and blame them for our cash crunch. Now I see it’s my fault. I’m the guy who’s responsible for chasing down the slow payers!”
We pride ourselves on providing accurate and relevant financial reports, and then working with clients to interpret these. That’s why we suggest looking at both cash and accrual reports, because each has a story to tell about how your business is performing. And, fortunately, QuickBooks allows you to easily toggle between the two.
If you’re not sure you have a complete picture of your business when you look at your financials, let’s talk. We love looking at your numbers and finding the opportunities to increase your top and bottom lines.