Better Data = Better Decisions. In today’s blog post I’m going to address two types of financial record keeping: cash basis and accrual basis accounting. When I take on a new client, my number one priority is to get the company’s financials in order so the business owners can make more informed decisions. It’s important to any company’s growth strategy to effectively and positively present their business to potential strategic partners such as banks or investors along with developing metrics to gauge progress.
Often, when we initially discuss company finances, the conversation focuses on symptoms the business is exhibiting rather than the underlying disease, for example, a new client might complain about the symptom of having cash flow issues. The problem might be a result of the company not having a line of credit to help out with the ebb and flow of an increased workload when business is heavy. When we dig into the reason why the company doesn’t have a line of credit as a cushion, we find the disease is that the business doesn’t maintain proper financial reporting. As a result, a bank can’t make any sense out of what the business owner is trying to accomplish, because they don’t see any supporting financials. As a result, lending institutions won’t extend them credit, which creates a problematic “Catch 22”.
Maintaining proper financial records is a key to business success. Many small business owners I work with don’t realize it’s acceptable, in fact it’s even recommended, that they keep their financial reporting on one basis of accounting and pay their taxes on another. In fact, the IRS asks businesses to explain the difference between how they keep their books and records versus the tax basis they’re filing.
So, what’s the difference between the two? In cash basis accounting, it’s a simple system of money in/money out. You record payments (and income) as you receive them and pay your bills, and incur expenses, when they’re paid. The accrual basis method of accounting can be a bit trickier. All of your receivables and your payables that haven’t been paid yet are on your balance sheet, where you can actually see how much money people owe you and how much money you owe others, keeping the expenses and income on the same cycle.
A prime example of a business that can effectively use cash basis accounting is a small passive income real estate investment company, which may be set up as an LLC. The business doesn’t have any accounts receivable, just rent coming in every month. Money going out the door might be one or two checks a month. In this passive income scenario, it’s absolutely okay to maintain your books on a cash basis.
On a cash basis, you’re only showing how much expenses you’ve actually paid, not how much expenses you have to pay. People get sloppy when they’re on a cash basis and they don’t bother to enter all their accounts payable in, so they think they’re okay because they’re always making just a little bit of money, when in fact the only reason why they’re making money is because they haven’t taken in any more cash to pay more bills.
If, on the other hand, the business provides products and services, accrual basis accounting is highly recommended for bookkeeping and record keeping. I prefer to have financial statements done in accordance with Generally Accepted Accounting Principles, or GAAP. By and large, Generally Accepted Accounting Principles recommend that companies keep their books and records on an accrual basis or a modified accrual basis.
Modified accrual accounting is used in industries such as construction where businesses book their income based off of the cost-to-date versus expected costs. Billings have nothing to do with profitability when it pertains to income levels, but adjustments must be made for over-building or under-building. This type of modified accrual accounting is called a percenThe Alexander Groupe completion method.
Another type of modified accrual accounting can be seen in manufacturing companies. These businesses book their income the same way, but they cannot claim profit until they ship their materials.
If your head is spinning with all of this accounting talk, I understand. It’s not everyone’s cup of tea. In fact, about 75% of my new clients need help in adjusting the way they manage their accounting.
If your business doesn’t have the proper reporting in place, you can make the wrong decisions, such as laying people off when it’s not necessary or failing to bring on additional help when you’re faced with a surge in business. When companies make the change to the correct method of accounting, they gain better data from which to make strategic and informed business decisions. And, having better data truly is the answer to all problems in business.
In my next blog post, I’ll be featuring a case study about one of my clients who needed more accurate financial reporting to obtain a more robust line of credit. We’ll discuss the company’s symptoms, the underlying disease, and the cure we came up with.
If you’re a small business owner struggling to figure out how to manage your accounting system, we can help, you, too. Contact us today for more information.
Information may be abridged and therefore incomplete. This document/information does not constitute, and should not be considered a substitute for, legal or financial advice. Each financial situation is different, the advice provided is intended to be general. Please contact your financial or legal advisors for information specific to your situation.