Cash accounting and accrual accounting are two concepts that are foreign to most people, but it’s important to understand the difference. As a business owner, if you manage your books on a cash basis, you will ultimately fool yourself. Why is this?
On a cash basis, you record things as they happen: Either as cash is going out the door or coming in the door. That’s often very different from when you’ve actually earned revenue or paid expenses. There are times in your business when you either provided a service or delivered a product and you didn’t get paid immediately, which means revenue would be entered in the wrong time period if done so on a cash basis. The same is true of your expenses; often you incur expenses in one period but don’t pay the invoice until a later period.
Let’s assume that you performed services on a contract in March, April and May but did not get paid until June. If you were doing your books on a cash basis, you wouldn’t show that you earned any revenue until you actually got paid in June. March, April and May would show no revenue related to this contract, even though you were earning the revenue as you performed those services. You would think that your business was going downhill.
Worse yet, what if you paid expenses in March and April related to this contract? With cash accounting, you would think your business was doing even worse! In June you would show revenue for the contract with no associated expenses. You might think your business was taking off, even though all the work had been done and the business was heading into a lull. Big picture – using the cash method of accounting for your financial statements is misleading; cash accounting actually leads business owners to make the wrong decisions – around staffing, pricing, ordering and all of the other key decisions an owner must make on an ongoing basis.
Looking at the same situation using the accrual method of accounting, the revenues would be spread out over the period that the service was provided and the expenses matched appropriately. The financials would show steady revenue and costs in March, April and May, with a decrease in June. Accrual accounting provides a much more accurate view of your finances and allows business owners to make better business decisions.
Accrual accounting is the only type of accounting that works for your business because it’s the only method guaranteed not to fool you. Accrual accounting will match up revenues with expenses and tell you whether or not the business was profitable. It also allows you to see trends in your business month over month to know how the business is performing. You will notice your Gross Margin will smooth out month over month, allowing you to make proper pricing decisions.
Cash basis accounting is fine for your taxes, it’s fine for your personal life, but it’s not fine for your business.