The difference between using cash-based accounting and accrual accounting is an important one for understanding and measuring the overall financial health of your business. And yet, that difference is frequently misunderstood. That’s because cash accounting is typically easier to understand (and many use their bottom line bank balance as a measure of how they are doing) and, by default, becomes the go-to system for entrepreneurs starting out.
Basically, cash accounting recognizes revenues and expenses when cash is received and spent — money in, money out. It’s a simple system to maintain, easy to determine when a transaction occurs and allows a business owner to simply look at their bank balance to see what they believe is the financial health of the business.
Accrual accounting, on the other hand, brings in the element of time and recognizes revenues and expenses when they are earned or billed, regardless of when the money is actually received or paid. The advantage to accrual accounting is that it offers a better big picture and long-term view of a business’s financial health. The downside is that it can limit awareness of cash flow — in other words, your business can be profitable on paper and yet have no money in the bank.
Here’s an example to better explain the two. Let’s say this month, we at Smart Foundations send an invoice to a client for $3,000, receive a bill for $2,000, pay $100 for a bill received last month and receive $1,000 from a client for an invoice sent last month.
Using cash-based accounting, our profit for the month would be $900 ($1,000 in cash received minus $100 in payments made). Using accrual accounting, our profit for this month would be $1,000 ($3,000 in revenue billed less $2,000 in expenses incurred).
The advantage to doing your books with cash-based accounting is, as already stated, it’s easy to understand and easy to administer; cash comes in, cash goes out and what’s left in the bank is profit — or is it? That’s the problem with cash-based accounting, you still have to pay your bills and collect the receivables. In the case of the example above, there may be $900 left in the bank, but will we be able to pay next month’s $2,000 bill if our client doesn’t pay their $3,000 one first?
Accrual accounting makes it easier to establish a savings process because you have a better vision of your business’s big financial picture. And, your A/R reports then become much more than simply a ledger to track payments. While cash-based accounting may work for an entrepreneur with little overhead and expenses, a small manufacturing company, for example, may have a lead-time of many months between when supplies are purchased and when products are sold — making seeing the big financial picture that much more important.
Your business has a business plan but when was the last time it was actually updated? It should be done annually, and our next blog post will have tips on how best to update your business plan.