14. Cash vs accrual accounting

0:12

S… Speaker 1 (14. Cash vs accrual accounting)

Don't let the title of this coaching video scare you off. This is a critical and massively misunderstood topic. If you decide to skip it, ask yourself if you're truly serious about mastering your business optics. Without the correct accounting reporting system, you've got no hope of ever running the business end of your business.

0:35

S… Speaker 1 (14. Cash vs accrual accounting)

Sadly, the vast majority of small business owners make the tragic mistake of attempting to keep score using the wrong accounting reporting methodology.

0:47

S… Speaker 1 (14. Cash vs accrual accounting)

Without making this more complex than it needs to be or turning you into a bookkeeper, believe me when I say there's a right way and there's a wrong way to keep score. If you keep score using the correct accounting methodology, you can accurately use the measuring techniques we designed into CFO's school board and as a result vastly improve your financial performance.

1:12

S… Speaker 1 (14. Cash vs accrual accounting)

If you attempt to keep score using the wrong accounting methodology, the optics you will receive will be distorted. Attempting to get a handle on your IQ by stepping on the bathroom scales is a lost cause and a waste of time. You have two options when it comes to the accounting methodology you use for your business, cash accounting or accrual accounting.

1:39

S… Speaker 1 (14. Cash vs accrual accounting)

Cash accounting is a huge mistake, and sadly, it's also the method most commonly used by most small business owners. Accrual accounting is the correct and, in my opinion, only way to keep score. To illustrate how critical this distinction is, according to Bloomberg, there are approximately 63,000 publicly listed businesses in the world.

2:09

S… Speaker 1 (14. Cash vs accrual accounting)

Guess how many of them use cash accounting? Zero, not one. How do you think they got so big? I promise you it wasn't by using the wrong yardstick. Success leaves clues.

2:24

S… Speaker 2 (14. Cash vs accrual 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.

2:40

S… Speaker 2 (14. Cash vs accrual accounting)

To my knowledge, there's only one business that is a pure cash business with no receivables, no payables, no inventory, which operates totally on a cash basis for 100% of all its transactions. The crack cocaine business.

3:01

S… Speaker 1 (14. Cash vs accrual accounting)

The rest of us take credit cards, receive IOUs, we get checks from our customers, we buy more inventory than we can sell in a month, we issue IOUs to our suppliers. If you happen to be in the drug business, you can keep using the cash method of accounting. The rest of us, we're going to rely on accrual accounting method to accurately keep tabs on where we are and what's going on inside our businesses.

3:29

S… Speaker 2 (14. Cash vs accrual accounting)

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. Cash accounting asks a different question. Cash accounting asks, did you spend some cash or did you collect some cash?

3:56

S… Speaker 2 (14. Cash vs accrual accounting)

If you did, record it. If you didn't, don't. 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 the work done in January in January.

4:19

S… Speaker 2 (14. Cash vs accrual accounting)

Cash accounting would tell you to record the revenue transaction in March, which is when you actually receive 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 in January.

4:38

S… Speaker 2 (14. Cash vs accrual accounting)

The problem is you incurred cost in one month and the associated revenue with those expenses was in a different month. You haven't matched or grouped the sales and expenses to the same time period. Matching is critical to measuring. If you have several customers...

5:00

S… Speaker 1 (14. Cash vs accrual accounting)

for example, who delay paying you for a couple 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 cost of generating a sale with the actual sale in the same time period, not with the receipt or the payment of cash.

5:30

S… Speaker 1 (14. Cash vs accrual accounting)

Your business might place an extra large order for inventory in January. Let's use the example of $9,000. In order to get the really good terms, you might have to pay for all of it up front in cash in January. The reality is you might sell or use it over the next three months at the rate of $3,000 per month.

5:56

S… Speaker 1 (14. Cash vs accrual accounting)

Cash accounting would tell you to record 100% of the inventory as an expense or a cost in January because you paid for it in January, which makes January's financial results look awful.

6:12

S… Speaker 1 (14. Cash vs accrual accounting)

In February and March, under cash accounting, 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 one of those months.

6:38

S… Speaker 1 (14. Cash vs accrual accounting)

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 sales with the cost of producing those sales 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's an easier example.

7:08

S… Speaker 1 (14. Cash vs accrual accounting)

Maybe your business owns a building and 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 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?

7:36

S… Speaker 1 (14. Cash vs accrual accounting)

Didn't it partially occur every month for the last 12 months? Accrual accounting would tell you to record one twelfth of the $12,000, which is $1,000 a 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, which is December, regardless of when it was used or owed.

8:03

S… Speaker 1 (14. Cash vs accrual accounting)

In cash accounting, you look great for 11 months out of the year, and in the month of December, you look incompetent. Accrual accounting is the only accounting system that gives you accurate optics of your true financial performance based on matching when you earned, owed, or used it, regardless of when you paid for it.

8:27

S… Speaker 1 (14. Cash vs accrual accounting)

In true cash accounting, there are no receivables. There's no payables. There's no inventory. In fact, there's no cash flow statement, which is probably why you've never seen one. Your check register has become your income statement. Deposits are recorded as sales. Checks written are recorded as expenses. This is as absurd as it is deadly.

8:53

S… Speaker 1 (14. Cash vs accrual accounting)

To measure your results and correct the underlying activities so that you can become more effective, more efficient, more productive, you must use the correct accounting methodology. So why do businesses use cash accounting to begin with? Well, partly it's because it's easier to understand.

9:14

S… Speaker 2 (14. Cash vs accrual accounting)

Most business owners don't understand the concept of earnings as a theory and that profits can't be spent. They think that if there's a dollar sign or a pound sign or a euro sign in front of a number, it must be cash. It's not.

9:30

S… Speaker 1 (14. Cash vs accrual accounting)

Bizarrely, business owners do understand that having profits but no cash to meet payroll or no cash to make a no payment is very possible. They just can't see why it's happening because of the cash accounting issue. Many times, small business accountants are more concerned about filing the tax return that you're in than presenting your financial information in a format that actually allows you to make good decisions.

10:00

S… Speaker 1 (14. Cash vs accrual accounting)

decisions and run the business end of your business. These accountants will sometimes try to convince you that cash accounting is less expensive, easier, faster, but you will never hear a competent accountant tell you that it's more accurate.

10:18

S… Speaker 1 (14. Cash vs accrual accounting)

The reality is that the government is partially responsible for this whole mess concerning cash versus accrual accounting because in most countries, the government expects you to pay your taxes based on a mostly cash kind of basis. Cash received, cash dispersed, not on the true accrual earnings of your business.

10:42

S… Speaker 1 (14. Cash vs accrual accounting)

On the other hand, the government is also largely responsible for getting most business owners to even keep any financial records of any sort. I seriously doubt the majority of small to medium-sized business owners would even bother keeping accounting records if there was no income tax reporting requirements, which kind of explains the anemic results that most business owners are getting.

11:09

S… Speaker 1 (14. Cash vs accrual accounting)

When you stop to think about it, having three report cards really is important. They are each designed to do entirely different things. A balance sheet to keep track of your things and stuff and whether you owe or you own your things and stuff. An income statement to keep track of whether or not your revenue of your business exceeds the expenses regardless of the timing of the cash changing hands and therefore if your business is theoretically profitable.

11:37

S… Speaker 2 (14. Cash vs accrual accounting)

A statement of cash flow to track where the cash is generated and used in a business. I'm warning you, it's highly likely your accountant or your bookkeeper will attempt to persuade you that cash accounting is okay.

11:55

S… Speaker 1 (14. Cash vs accrual accounting)

They will tell you that cash accounting is cheaper to perform, easier to understand, less complicated, and that it will minimize the year-end calculations required to prepare your tax returns. They will try to convince you that the cost of switching is egregious, and it's not. I'm sure these are nice, well-intentioned people with whom it would be fun to swap debit and credit jokes, but they're dead wrong.

12:24

S… Speaker 2 (14. Cash vs accrual accounting)

You can keep this cash accounting accountant to help you file your tax returns if you want to, but hire someone who will help you do something other than pay your tax bill to the government. The primary requirements to convert from cash to accrual accounting are four things. Number one, match the revenue and the cost of that revenue into the same time period in which you earn it, you owe it, or you use it.

12:53

S… Speaker 2 (14. Cash vs accrual accounting)

Number two, record the sales in the time period in which they occur, which is when you earn it, which means you're going to track and record your accounts receivable on the balance sheet. Number three, record your expenses in the time period in which they occur. You owe it, which means you're going to track and record your accounts payable on your balance sheet. And number four, record your inventory in the time period in which you use it.

13:23

S… Speaker 2 (14. Cash vs accrual accounting)

which means you'll track and record your inventory on the balance sheet. Do not be tempted to hit the button in your QuickBooks or MYOB or accounting software that lets you convert from cash to accrual accounting with the touch of a button. That button does no good if you haven't followed the four rules outlined above. Better yet, don't worry about all this accounting stuff.

13:52

S… Speaker 1 (14. Cash vs accrual accounting)

Go out and hire someone, part-time is better than nothing, who knows what they're doing. Hire someone who can get your accounting straightened out and you get back to running the business end of your business. If you need a referral on who you can hire, get in touch with us. I know people who are very, very good at all this accounting stuff.

14. Cash vs accrual accounting

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