Cash Basis vs Accrual Basis Accounting

Cash Basis vs Accrual Basis Accounting

Believe it or not, we deal with this issue of whether to use cash basis vs accrual basis accounting all the time. Many companies start from scratch with one person doing the accounting from home or a small office. Over time, their needs grow. It’s normal to see changes within the organization, especially when companies grow. As you grow, it is critical that you do not neglect the accounting process.

Cash Basis vs Accrual Basis Accounting

What is the difference between cash basis vs accrual basis accounting?

Cash basis accounting is, in its form, the most basic way of tracking your income and expenses based on the actual cash that comes in and goes out every day. Imagine the one employee/owner hot dog stand on the street corner. That business owner goes out early in the morning, pays $2 in cash to the vendor that sells him the hot dog meat and buns. Then, he goes out to the street corner and sells the hot dog for $3 in cash and puts the cash in his pocket. That vendor made $1 profit in cash from the sale of a single hot dog. He sells many hot dogs during the day. This business person is on a cash basis way of tracking his business. In this business owners company there is no difference in timing of transactions between periods.

Moving to Accrual Basis Accounting

If you are bigger than the hot dog stand, then you should probably consider moving to an accrual basis for capturing your transactions and accounting. Why? Because we live in an accrual world. Not a cruel world.

If you are reading this blog, then you probably sell a product or service. Most likely, you give your clients terms to pay your invoice. Maybe it is 10 days, 15 days, or even 30 days… But you give your clients time to pay their invoice. You just created accounts receivable (A/R). In the same respect, you purchase things from your vendors – material or services. Likewise, you most likely do not hand your vendor a check or cash that day, but they give you time to pay for the item you just purchased. So, you have accounts payable (A/P). This is probably more realistic. Guess what? You just created accruals.  In this example there are differences in the timing of the actual transaction and when the transaction process if totally complete and settled.  You have to track what is owed to you as an asset, and you have to track who you owe as a liability.

In reality, this is the world we live in and accrual basis accounting is recommended for virtually any business. We live and transact in an accrual environment.

Keep up to today’s expectations when trying to grow or add value to your organization! Click here to access our Top 10 Destroyers of Value whitepaper and protect against anything that may be destroying value.

Accrual Basis Accounting

There are a reasons why major businesses and small successful businesses keep their accounting records on an accrual basis.  One reason is because that is how they generate financial statements that accurately reflect their operations and business, the other is because Generally Accepted Accounting Principals (GAAP) requires companies to be compliant using the accrual basis. A crucial part of the accrual basis is the matching principal – matching revenue and expenses.

You Are 60-90 Days Behind Your Company

The fact is that you are 60 or 90 days behind running your company if you are keeping your books and records on a cash basis. I have actually seen 30-year-old companies with revenues north of $100 million dollars and millions of dollars of expenses on a cash basis. And the recurring comment I get from these business owners is that they have trouble forecasting their business and they think they know what their margins are but really they are not sure. Especially in a business where there is manufacturing or assembly involved, or a service business that is beyond a half dozen people in size, you can bet your margins are wrong if they are on a cash basis.

By not having your accounting records on an accrual basis you are truly 60-90 days behind your business, you are not able to measure or forecast working capital and you will eventually run in to problems.  Some of these problems may be life threatening to your business if there is a downturn in the market or global economy.

It is More Than Margins and Operations

Knowing your margins on an accrual basis and understanding your profit and loss statement is critical. But you also need to know that your balance sheet is correct and truly represents what you have and owe. If you are on a cash basis, then you do not know what you have or owe. For example, prepaid insurance, payroll liabilities, purchase orders entered into your accounting system have not been invoiced by your vendors. As a result, these are all things that will not show up on your balance sheet if you are not keeping your books and records on an accrual basis.

At our firm, we’re are often engaged to help a client company transform their accounting records from cash basis to accrual basis. And the outcome is always positive as management is very happy to know that they can now get good accurate reports and their margins finally make sense. Now they can use their financial statements as one of many tools to run their business.

Cash Basis vs Accrual Basis AccountingA Valuation Perspective On Cash Basis vs Accrual Basis Accounting

You may have a very profitable company on a cash basis, but your financial statements are not going to be accurate. Your company will suffer when it comes down to valuation. Sophisticated financial buyers, strategic buyers and bankers understand that some private companies are still run on a cash basis, but guess what? They are going to discount the value of your company because it is on a cash basis. Eventually, the buyer will want the company they acquire on an accrual basis anyway. This is just another way that you can leave value on the table during a transaction to exit.

Switching from cash basis to accrual basis accounting is just one example of how to protect your company’s value. But there may be other destroyers of value lurking in your company. Don’t let the destroyers take money from you! Access our Top 10 Destroyers of Value whitepaper here.

Tax CPA vs Management CPA

What is ironic is that many Tax CPAs that prepare their clients tax returns or keep books and records do not care if you keep you books on an accrual basis. Actually, if you file cash basis for the IRS and your tax return, it will be easier for your tax preparer to keep your books on cash basis. But that is hurting you from a management perspective. Do not let your tax preparer tell you that you can just as well run your business on cash basis. He or she is simply wrong and too lazy. We can assume that they have never run a business. As a business owner, you need management books/records and management financial statements on an accrual basis and hopefully complaint with GAAP to run your business. They must be kept on an accrual basis so that they are more meaningful as a financial leadership tool.

Remember, CPAs are not all alike. Many of my friends still ask me if I am busy between January and April because I am a CPA. What the heck? I do not even prepare my own tax return, because I am not a Tax CPA.

CPAs are actually very different. The following are some of the different areas CPAs specialize in and many times do not cross other areas:

  • Taxes
  • Audits
  • Management and Operations
  • SEC Reporting
  • Forensic Accounting

Why Not Keep Your Accounting Records On An Accrual Basis?

There is no reason why you would not want to keep your accounting records on an accrual basis. (I am not referring to your tax books and records.) Your operational management financial statements should be kept on an accrual basis. Any decent accountant or controller can help you keep your books and records on an accrual basis. We can also assist you convert from cash basis to accrual basis as we have done this time and time again. We have our process in place to make this as efficient conversion.  In conclusion, there really is no good reason to keep your books and records on cash basis.

To discover other potential destroyers of value, click here to access our free Top 10 Destroyers of Value whitepaper.

Cash Basis vs Accrual Basis Accounting

Strategic CFO Lab Member Extra

Access your Exit Strategy Checklist Execution Plan in SCFO Lab. The step-by-step plan to get the most value out of your company when you sell.

Click here to access your Execution Plan. Not a Lab Member?

Click here to learn more about SCFO Labs

Cash Basis vs Accrual Basis Accounting

3 Responses to Cash Basis vs Accrual Basis Accounting

  1. Michael huthwaite March 7, 2018 at 11:01 am #

    I think your point of view is coming from an accountants point of view rather than a strategic finance point of view. Accrual vs cash method from an accounting standpoint is one thing. But thinking in terms of cash vs accounting (arcrual or cash method) is really the way to value a business as well as manage it.

  2. zemene Aychew March 8, 2018 at 9:01 am #

    Yes, We are living in the accrual environment. Maintaining books of accounts in accrual basis helps the business to fairly represent their financial position. It also helps owners and any information users to understand what is really going on in the business.

  3. Jr bechard May 7, 2018 at 7:24 pm #

    This article is very true and instructive well done. Let us have these such article sent to us regularly
    My email is jr.kpimauritius@gmail.com
    Thank you for best regards
    Jr bechard from kpi Mauritius
    Chartered accountant

Leave a Reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.

 Download Free Whitepaper Today!

ACCESS NOW!