Cash vs. Accrual Accounting
CFO Scoreboard is an incredibly powerful tool regardless of the accounting methodology you use. CFO Scoreboard will enhance your optics, allowing you to make better decisions and more money.
There are two types of accounting methodologies:
- Cash Accounting- Most commonly used by small businesses in the United States because the IRS requires the tax returns of small businesses to be filed using this type of accounting. Cash accounting records only those transactions in which actual cash changes hands. If it doesn’t involve cash, cash accounting ignores the transaction until the cash is actually deposited or paid out. (Obviously this delay in recording a transaction causes havoc with timing issues on financial statements.1) An income statement prepared using cash accounting ignores accounts receivable, accounts payable and inventory.
- Accrual Accounting- Used exclusively by larger companies, including 100% of all publicly traded companies. Accrual accounting asks three questions: “Did you earn it? Do you owe it? Did you use it?” If the answer to any of these questions is “Yes,” then you record it as a financial transaction in your financial report cards in the month in which the event occurred. Cash accounting asks, “Did you spend some cash or collect some cash?” If you did, record it in the month in which the cash changed hands. If you didn’t, don’t. Accrual accounting tracks accounts receivable, accounts payable and inventory on the balance sheet and therefore is a more accurate reflection of the financial performance of a business.
CFO Scoreboard provides you the ability to analyze your business’ financial performance regardless of the accounting methodology used. If you are using cash accounting, CFO Scoreboard has a toggle selection that enables you to switch from month to month trend analysis to trailing 3 months or trailing 12 months trend analysis, either of which will smooth out the lumpiness usually found in cash accounting. By switching to a trailing 3 or 12 months, you can still see the trends and use your accounting data to help you make informed business decisions… However, you will want to transition to accrual accounting (which might entail hiring a different accountant to provide you with management accounting reports versus tax accounting reports) so that you also have access to the financial optics of monthly trends and thereby make more immediate decisions.
Sometimes your business will make a sale (earn it) in January, but not collect the money until March. But you paid the light bill for January, in January and your employees all got paid for work done in January, in January. Cash accounting would tell you to record the revenue transaction in March, which is when you actually received the cash. And Cash accounting would tell you to record all your expenses when you wrote the checks for the electricity bill and the payroll, which was January. The problem is you incurred costs in one month and the revenue associated with those expenses in a different month. You haven’t matched the sales and expenses to the same time period. Matching is critical to measuring!
If you have several customers, for example, who delay paying you for a couple of months, on a cash accounting basis it looks like you’re really struggling on your income statement until the month that everyone pays and then you look like a hero.
Accrual accounting, on the other hand, says that it is important to match the costs of generating a sale with the actual sale in the same time period, not with the receipt or payment of cash.
Your business might place an extra-large order for inventory in January. Let’s use an example of $9,000. In order to get the really good terms, you might have to pay for all of it, in cash, in January. The reality is you might sell (use it) the inventory over the next three months at the rate of $3,000 per month. Cash accounting would tell you to record 100% of inventory as an “expense” or cost in January because you paid for it in January, which makes January financial results look awful. In February and March, you didn’t have to use more cash to buy additional inventory (because you had enough left over from the January purchase) so cash accounting would say there were no inventory costs or cost of goods sold in February and March, even though you actually used $3,000 of your inventory in each month. In cash accounting, you look like you’re going broke in January but in February and March you look like the reincarnation of Bill Gates.
Matching the revenue or sale with the costs of producing that sale in the same time period is critical to accurately keeping score… and that’s what accrual accounting does. This is getting pretty technical here and I don’t want to lose you, so here is an easier example.
Maybe your business owns a building. The property taxes and insurance are due in one lump sum payment every December. Suppose these two expenses total $12,000 for the entire year. You will certainly write the check in December for $12,000 and your cash will go down by $12,000 in December, but when did the expense really occur? Didn’t it partially occur every month for the last 12 months? Accrual accounting would tell you to record 1/12 of $12,000 ($1,000/month) every month as an expense. Cash accounting would tell you to only record it as an expense in the month that it was paid (December), regardless of when it was used or owed. In cash accounting you look great for eleven months out of the year and the month of December you look horrible.
I will say it again: Regardless of the accounting methodology you use or whether you do or don’t switch to accrual accounting, CFO Scoreboard is an incredibly powerful tool that will enhance your optics, allowing you to make better decisions and more money.