accounting basics

You’re an entrepreneur who is excited about growing your small business. Maybe you’ve identified the perfect niche market designing websites for local restaurants or installing high-end home security systems. You’re passionate about your company’s services, growing your business, and polishing your brand. Your focus on those elements of your business is really important to your success, but you might be overlooking an equally important accounting decision that you need to make: Do you use cash basis accounting, or do you use accrual accounting? After years of working with small businesses, I am convinced that accrual accounting is the best option for your company, especially as your company grows and looks for new opportunities.

Cash Basis Accounting vs. Accrual Accounting

Small businesses — which often have to learn basic accounting informally and quickly — can use either method of accounting, but the methods are different.

When using cash basis accounting, a sale is not recorded as a sale until your customer pays you, and an expense is not an expense until you pay for it. Money has to change hands in order for you to account for it.

When using accrual accounting, sales are recorded as accounts receivable at the moment you sell something, such as when you send an invoice to a customer. Expenses are recorded as accounts payable when you receive an invoice from a vendor.

Let’s think about a situation in which you are the owner of a brand-new plumbing company. In April, you performed 10 service calls and sent your customers their bills, totaling $5,000. At the end of the month, five customers had paid their invoices for a total of $2,500. That same month, you paid an invoice for some tools that you bought for $800.

If you are using cash basis accounting, you recorded a profit of $1,700 — the amount your customers paid you minus what you paid for the tools.

If you are using accrual accounting, you recorded a profit of $4,200 — the amount of the invoices you sent minus what you paid for the tools.

Your business is going to have very different financial statements at the end of April depending on the type of accounting you choose, even though the exact same events happened in both instances.

Why Small Businesses Prefer Cash Basis Accounting

I certainly understand why small business owners are interested in cash basis accounting. Here are a few reasons I think they do.

First, you have thousands of tasks to perform and decisions to make.

When you are just starting a business cash basis accounting is simple enough that it seems like a way to save time. Creating a financial statement doesn’t involve much more than looking at your bank accounts. If you see money deposited, you can consider those sales. If you see money paid, those are expenses. It’s easy for you to see a reasonably accurate record of your month-to-month cash flow.

Second, you might have a small business that has its customers paying immediately for services.

These pricing models are referred to as payment due at time of service. For example, think about a boutique financial advisory service. If customers pay immediately at the end of each planning session, there’s not much need for accounts receivable. Those types of small businesses might not see the need for the extra complexity involved with accrual accounting.

Third, cash basis accounting affects when you pay taxes for your business.

If your small business performs a service at the end of December but doesn’t receive payment until January, it doesn’t pay taxes on that income until the next year under cash basis accounting. However, your business is still going to pay its taxes at some point (and recording income received near the end of one year as income the next year is fraudulent, even if it sometimes happens). My point is that this often-mentioned benefit of cash basis accounting really isn’t that big of a benefit.

Even worse, unscrupulous small business owners might attempt to use cash basis accounting to manipulate their income statements. Let’s say you start a mobile pressure-washing company. During the day, you drive from house to house and pressure-wash decks, driveways, siding — you name it. If it has mold or dirt, you pressure-wash it. You didn’t have much money to start the business, so you used a loan to purchase the pressure washer and van. If you stop paying the bills for that pressure washer and van, you don’t record those transactions. At that point, your company’s income statement looks much better than it really is because, after all, you don’t have those expenses recorded.

Despite its benefits, cash basis accounting simply isn’t the best solution for a small business. In fact, it’s not even in accordance with the Generally Accepted Accounting Principles.

Why Your Small Businesses Should Use Accrual Accounting

There are some great reasons I think small businesses should use accrual accounting, even if it can seem more difficult. First, it allows you to track revenue and expenses more easily. Second, it helps you create more comprehensive financial statements for people outside of your company. Third, it allows you to calculate key ratios that you might need to know as your business grows. I’ll explain these one at a time.

First, consider how complex your business operations are as you are just starting.

Maybe demand for your pet-sitting business has exploded as your customers spread the word about how reliable you are and how well you care for their pets. You might have hired a few employees. Pretty soon, you find that you’re having trouble tracking who owes what. You know you are due some cash soon, but how much? And when? Ms. Jackson owes exactly how much, again, for watching her Labradoodle? Are you going to remember that in a few weeks?

With accrual accounting, you simply record the amount that Ms. Jackson owes you as an accounts receivable transaction. That gives you some peace of mind when you think about that amount offset against the expense that you recently had for your website redesign with the prominent picture of that Labradoodle at the top. You know immediately where your money is going and where it’s coming from.

Second, as your business grows, other people are going to be reviewing your financial statements.

Accrual accounting gives those people a better idea of the shape of your company. If your graphic design business looks thin on cash one month because you had to pay for a better computer, a quick glance at your accounts receivable allows anyone to see that your cash flow for the following month looks great because your clients are going to be paying you many times the cost of that new equipment.

Keep this in mind as you think about your future needs for credit. Maybe you need a short-term line of credit because of increases to your accounts receivable. If you hand your banker a balance sheet using cash accounting, he won’t even see that you have accounts receivable because it won’t be on your balance sheet. Using accrual accounting, your banker has a better understanding of the health of your company rather than a misleading one based on a snapshot in time.

Third, if your company is experiencing explosive growth and is looking for more credit to continue expanding, you want to keep your banker happy.

The banker is going to review your financial statements and calculate a few key ratios. These ratios are better calculated using accrual accounting.

Take the current ratio, for example. A current ratio is used to get a quick snapshot of a company’s cash position. Your banker calculates this ratio by dividing current assets by current liabilities. You’re not going to have an accurate current ratio using cash basis accounting because your accounts receivable and accounts payable are not being reported on your balance sheet.

Traditional lenders might not want to deal with a business using cash basis accounting to create that type of balance sheet, or they might not be able to account for some money that’s owed to you as they try to underwrite a loan. That’s not good in either case.

Even if you do find a lender willing to work with you while you use cash basis accounting, once you have to start providing other supplementary documents, you increase your chances of committing a mistake — and that might lead to you getting turned down for a loan. Accrual accounting helps you avoid those mistakes by giving your banker the information he or she needs right there on the balance sheet.

And if your small business as a rental property manager explodes, you add employees, and you expand beyond your wildest dreams, potential buyers are going to want to see the most comprehensive financial statements possible — that means you need to be using accrual accounting.

What to Do if You Want to Switch to Accrual Accounting

Making the switch is easier than you think. Because you might not be familiar with all of the tax laws that might apply to your specific business, I recommend talking with your certified public accountant — or hiring a CPA if you don’t currently have one. Your CPA can tell you about any possible tax consequences of making the switch.

The actual switch, though, is easier today than ever. Often, with today’s accounting software, such as QuickBooks, you might just need a few mouse clicks. Once you’ve switched to accrual accounting, make sure you’re consistent. You don’t want to hand someone statements using cash basis accounting one time and statements using accrual accounting another.

Once you’ve made the switch, ask your CPA to help you calculate your current ratio, your accounts payable days (how long it takes you to pay your vendors or other creditors), your accounts receivable days (how long it takes customers to pay you), the percent of gross profit to sales, and the percent of cash flow to sales. Use these ratios or key performance indicators to keep track of the monthly performance of your business — you will be better informed to make decisions, and you’ll be able to tell others outside of the company about your company’s health.

If you’re serious about growing your business, it’s time to embrace accrual accounting. It might be more difficult at first, but accrual accounting benefits your business in the long run, giving you better access to credit and — hopefully — better access to buyers when the time comes.

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Terry Lammers, CVA, is managing member of Innovative Business Advisors. He is also the author of “You Don’t Know What You Don’t Know: Everything You Need to Know to Buy or Sell a Business.”

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