You’re driving 70 miles per hour on the highway, heading west towards your vacation cottage in the mountains. The only thing standing between you and your well-earned 7 days of relaxation is 10 miles of an incredibly dense, pea-soup fog. You’re reluctant to slow down as you think about how nice it is going to be to unpack your bags and sit on the porch overlooking the valley. But you truly can’t see anything – no road signs, no tail lights, nothing.
What do you do?
If this were a real situation, you would slow down and turn on your hazard lights, right? You would probably check Google maps to find out if there are any car accidents up ahead. You might even pull over and decide to wait until the fog lifts. The bottom line is that there are things you would do to stay safe and figure out a game plan. You would not blindly keep speeding down the highway on nothing but a hope and a prayer that you don’t miss your exit, or worst case scenario, hit another car.
If you run the financial side of your business using a cash basis of accounting, you are in the car speeding down the highway in dense fog with hazards coming that you can’t see. As a business owner, this might be a surprise to you. But do you wonder why your Profit & Loss statement (P&L) shows net profit really high one month and then really low (or even negative) the next? Your profit seems to be oscillating back and forth and is anything but consistent. It just doesn’t make sense and you find it difficult to make business decisions.
As a Fractional CFO, it’s my job to clear up the financial foggy areas that are leading entrepreneurs towards a potential collision! If you are using cash basis for your business, and need help getting your books on a clear path towards success, contact me and let me help you avoid a financial collision.
Accrual vs. Cash Basis – What’s The Difference?
Many businesses record their financial transactions using a cash basis, which means it is recorded when activity hits your bank account. If a transaction has no effect on cash (such as depreciation, or deferred interest on an EIDL loan when payments are not being made), nothing is recorded.
The alternative way to record activity is using accrual basis, which provides the most accurate picture of your business position, as well as your profitability. With accrual basis, your financial activities are recorded when products or services are received (expenses) and delivered (revenue).
Let’s think back to that car we were driving down the highway towards our vacation. When the dealership purchased that vehicle in January, it was not immediately sold to you. It sat on the lot for a full 2 months before you came to take a test drive and decided to make the purchase.
Using a cash basis, the dealership recorded the purchase of 60 vehicles in January, but they only sold 5 cars. A high expense with little revenue to show for it. By the time March rolls around, their profit is looking much better – they did not record the expense of vehicles purchased because there are still cars sitting on the lot, but they did sell 20 vehicles – yours included. This month’s P&L statement is looking much better, with high revenue and low expenses.
Alternatively, if the dealership uses accrual basis, that up and down profitability view from using cash basis is leveled out and instead provides a more accurate picture of what’s actually happening. Those 60 vehicles purchased to provide inventory for the first quarter of the year are spread out over the time period they are sold instead of being recorded all in January: 5 in January, 35 in February, and 20 in March. Then their expense of purchasing the vehicles in each month will be matched to when the revenue comes in from their sale.
Accrual basis aligns with one of the main accounting principles called the matching principle. This means your activity is recorded in the correct time period so that the revenue and associated expenses are matched. For example:
- 60 cars purchased in January are held in Inventory as an asset until they are sold.
- Since 5 cars were sold in January, 5 cars move from Inventory on your balance sheet into Cost of Goods Sold on your P&L so that it matches the revenue from the 5 cars sold in January.
- 35 were sold in February, so 35 cars move to Cost of Goods Sold to match February’s sales.
- In March, the last 20 are moved to Cost of Goods Sold with March’s sales. They match!
Accrual basis is the best method with which to make clear decisions on the path forward for your business.
Quickbooks Made Me Do It! The Danger Of the Cash/Accrual Button and Bad Bookkeepers
Many business owners – and even bookkeepers – are surprised by the recommendation to not use cash basis when it comes to using healthy financial practices. Quickbooks doesn’t help since it has a button to “toggle” between cash and accrual. This button often makes people think they can switch between the two easily and one is just as good as the other. Neither is true!
The person in charge of your financial books is the only person who can truly know the difference between cash and accrual status in real time. This is because accounting software doesn’t have 100% knowledge of what is happening in your business. For example, if an invoice is recorded in Quickbooks in July but the service was received in June, how do you think the system will show that on a report? It has no idea that the service was received in June, and therefore misrepresents when the expense was truly incurred.
I’m not saying you can’t use Quickbooks. It’s a great tool for businesses that offers a lot of value. But even with Quickbooks, you still need a well trained bookkeeper to truly keep accrual basis books. It’s the job of your bookkeeper to know when to communicate information (add transactions) to Quickbooks in order to keep your financial records accurate.
Now, I’ll also offer a word of warning here about bookkeepers. Not all bookkeepers fully understand accounting, which is a huge problem when a business owner outsources this task and then ignores it. If you rely too heavily on your bookkeeper, you are leaving room for mistakes that can compound into huge problems. There are many ways to know if your books are being kept accurately, one of which is to educate yourself in the best practices and then check in periodically for red flags.
- Does your bookkeeper know how to keep your books on an accrual basis?
- Are they using the accrual/cash button in Quickbooks to toggle between the two?
- When you ask them about it, do they say accrual accounting is too complicated or too much work?
If you see any of these red flags, it’s time to find a new bookkeeper!
A Note About Accrual Basis And Taxes
If you keep Quickbooks on an accrual basis in the proper way, that does not necessarily mean you have to file your business’ tax return on an accrual basis. Your tax return can still be on a cash basis if that is what’s best for your situation. You can ask your tax advisor if that is what they recommend. This is so common that the IRS has a specific schedule (M-1) to reconcile the differences.
It’s a benefit to be able to decide how it’s best to file taxes – you can choose what’s best for you!
Partner With Huxley CPA
The best way to clear up the fog and drive your business towards success with a clear view ahead of you, is to keep your financial books on an accrual basis. This provides the best insight into the health of your business and can be critical when making business decisions such as raising prices or reducing expenses. Contact Huxley CPA today to convert your books to accrual basis or do a financial health check.