All financial reports are not created equal.
Generally, businesses use one of two basic methods to track and report revenues: cash basis or accrual basis. Both methods are useful, but each provides different insights about your financials. What exactly is the difference between cash vs accrual accounting, and how can you use them to move your business forward?
Cash vs Accrual Round 1: Cash Accounting for Easy Cash Flow Tracking
Cash-based bookkeeping reports money when it actually enters or leaves your bank account. Let’s say your business pays employees on November 1 for work done in October. With cash accounting, those payroll expenses will most likely be recorded in November when your employees cash their checks. If someone waits until December to cash theirs, the expense is recorded in December.
Benefits of cash accounting:
- It’s simple
- It shows how much money you have on hand
- No need to adjust your books in order to file taxes, since you just have one set of books
Cash accounting can be useful for providing a snapshot of your business at a point in time, but it’s not the best tool for making strategic growth decisions.
Cash vs Accrual Round 2: Accrual Accounting for Better Business Insight
Accrual accounting is a more advanced approach that counts income and expenses in the month they “belong”. In other words, revenue when you earned it, expenses when you incurred them. In the payroll example above, October labor expenses are recorded in October, regardless of when you cut checks or employees cash them. Accrual accounting is more complex, but it’s extremely important as your business grows.
Benefits of accrual accounting:
- It offers a more accurate view of income and expenses during a specific period
- Gives you a better understanding of your business’ profitability
- Lets you plan ahead with confidence
When it’s time to hire people, buy new equipment or create marketing plans, you need to know more than just how much cash is in your account today. You need a clear picture of business performance over time so you can accurately budget for expenses. Accrual-based accounting also allows you to spread your revenue out equally over project terms and puts you in a better position to secure financing.
With accrual accounting done right you can have confidence that income, expenses, and net income really represent how the business is performing. However, it’s absolutely critical that you also monitor cash flow and give it equal importance to net income when reviewing your books.
“Net Income and Cash Flow: Two sides of the same coin. It’s absolutely critical that you also monitor cash flow and give it equal importance to net income when reviewing your books.”
Cash flow can fall behind net income if you’re slow to collect payments from customers or if you have to make large inventory purchases. So, you need to keep both accrual-based net income and cash flow front and center – they’re essentially two sides of the same coin.
What Does This Mean for Your Business’ Financial Reporting
Now that you understand the two main types of financial tracking for your business, how does that affect your reporting? For starters:
- An accrual-basis report shows all invoices and expenses, paid or not
- A cash-basis report only reflects actual income received (into your bank account) and expenses paid (from your bank or credit card account)
We recommend accrual accounting for your business management from day one. If you’re still using cash accounting, don’t worry. It’s not too late to switch.
The first step towards accrual accounting is to record all customer invoices and vendor bills in the month that the revenue is actually earned or expense actually incurred. In other words, the date of the invoice or bill.
As your business gets more complex, you’re likely to find yourself in situations where it makes sense to accrue or defer revenue or expenses, such as:
- Projects that span multiple months
- Prepayments from customers or to vendors
- Large asset purchases like inventory or equipment
Imagine you just got a big payment from a customer for a multi-month project. Your bank account is flush–but that cash has to last for months to come. Only accrual-based accounting allows you to properly budget for that.
Optimizing Reports for Accrual Accounting in QuickBooks
Popular accounting software programs like QuickBooks allow for switching between cash or accrual accounting, but the functionality is limited.
You can “turn on” accrual-based reporting in QuickBooks to report invoices and bills in the month of the invoice or bill date. However, using this feature doesn’t magically transform your business’ books to accrual accounting.
Recording customer invoices and vendor bills in the appropriate month is the first step towards accrual accounting, but fully switching over takes a little more effort.
- You need to review the timing of your revenue generation vs. cash collection and determine if any accrual or deferral processes need to be implemented to accurately report revenue in the month generated. Repeat the process on the expense side.
- Once you identify any timing discrepancies, you need to implement a process as part of the month-end close to enter journal entries that properly accrue or defer revenue and expenses.
When done right, you’ll get the benefit of having a Profit and Loss Statement that accurately reflects the performance of the business – you’ll finally truly know if the business was profitable or not, regardless of how much cash came in (or went out!) the door.
Keeping an eye on your bank account is simple, but it’s a terribly inadequate way to determine your business performance.
If you’re still running your business by the ancient “bank account business management” system, we can help you break that bad habit and begin to truly understand your business performance.