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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.

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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

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Cash Basis vs Accrual Basis Accounting

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You Can’t Afford Not to Spend Money on the Accounting Department

As a former CEO to some CEOs, this Blog is to my counterparts that “don’t know what you don’t know.”  I have seen time and time again closely held businesses that have experienced growth make the same mistakes over and over again. To the CEO that believes bookkeeping is a necessary fixed cost that should be minimized, here is a money making tip. You can’t afford not to spend money on the accounting department if you want to be successful.

The Big Mistake

Your company has grown over the years; you have experienced good times and maybe some bad times. Additionally, you have taken a nice paycheck and sometimes, some nice bonuses.  You got used to a certain life style. And you did all of this with a bookkeeper that does not cost you much.  But your company has grown. Still in the back of your mind, you know something tells you that you are not comfortable with your accounting records. But you elected to keep cost down for the bookkeeper and you do not spend much on accounting.

You Can't Afford Not to Spend Money on the Accounting Department

My Tax CPA Does It All

Maybe until now, some of you have your outside CPA that prepares your tax return also prepare year-end financials. This is not a knock-on tax preparers, but your CPA that prepares your tax return is an expert in one of many fields CPAs work in. For example, I am a CPA, but there is no way I would prepare my own tax return. Tax laws change way too often. I just want to maximize my deductions and pay my fair share of tax, but not more than that. That is why I have my tax CPA prepare the tax return.

But over the course of my career, I have found that most tax CPAs do not have operational expertise. They have not run a manufacturing or service business, nor have they had any P&L responsibility. The Tax CPA is considering accelerated depreciation, maximize expenses, etc. This is quite the opposite from a management set of financial statements. The role of the CPA Tax preparer is totally different from a “operational” CPA, Controller or even CFO.

Minimizing the Back Office For the Wrong Reasons

Most CEOs that I have worked with argue to minimize the cost of the back office. That includes the cost of preparing financial and accounting records. But think about this… The Securities and Exchange Commission (SEC) does not require public companies to prepare their financial statements according to Generally Accepted Accounting Principles (GAAP) because they pulled this out of thin air as another way to regulate.  The SEC requires public companies to prepare their accounting records and financial statements based on GAAP because it is the best way to present fairly the results of your financial operations to third parties reading your financial statements.  In other words, It’s the RIGHT way to keep your books!

In some cases where there is significant debt and exposure, some banks also require that the company present your accounting records based on GAAP – regardless of whether it is a Public or Private company.  Some debt situations even require an audit. The banks simply make it one of the covenants related to your debt. When you present your books and records per GAAP, you have accurate financial statements, everyone is assured your accounting is correct.

The Importance of Using GAAP

So, if a lot of brain power has been put into coming up with GAAP, and the general consensus is that GAAP is the right way to present your financials and accounting records.  Why would you as CEO not require that your financial statements be presented per GAAP?

I have been an “operational” type CPA for over 27 years now. In addition, I have held the office of CEO twice. I have used my expertise in public company environments and private companies both as an employee and as a consultant in the U.S. and in other countries. I have seen many very successful small, medium and large private companies and they were all keeping their financial records per GAAP. Yet, I have NEVER seen a significant company (not a micro or small business) be successful and properly run without keeping their books and records per GAAP.

So why is it that CEO’s of closely held (private) business still permit their accounting records to be kept some other way?   The answer: they do not want to spend money on a fixed cost such as accounting. But they will spend money on the sales team, hunting leases, extravagant meals or parties.

Not getting the basics down – such as GAAP – leaves money on the table when you are exiting the company. Increase value with our Top 10 Destroyers of Value whitepaper.

You Can't Afford Not to Spend Money on the Accounting Department

You Can’t Afford Not to Spend Money on the Accounting Department

These are real life examples and outcomes of minimizing the cost of your accounting department that I have lived…

The service company incorrectly books gains on U.S. dollar receivables. In conclusion, they had to reverse $8 million from earnings.

I have seen this one several times. The company does not have some large assets on the balance sheet, because their tax preparer said they used accelerated depreciation. As a result, the balance sheet assets are severely understated. Hint: your value is understated. IT’S ABOUT THE MONEY DUDE!

The manufacturing facility does not properly accrue costs. As a result, their margins are way off, and the CEO wondered why they were always short on cash.

The company did not properly reconcile accounts including cash. This led to fraud.

The company did not properly recognize revenue. In conclusion, the company was understating revenue by millions of dollars.

I can go on and on with more real-life examples.

If you do not have your financial statements presented per GAAP, how are they prepared and presented? Do you really know your margins in your P&L. Do you really have all your assets, liabilities and equity presented correctly? Is your P&L, Balance Sheet and Cash Flow statement presented correctly? Guess what? Your ratios that your controller or CFO should be analyzing are not correct.

Leadership Needs to Believe in GAAP

Why do you think Exxon, Walmart and all other public company CEO’s believe in GAAP?  I have also seen many small, medium and large closely held private companies keep their accounting records per GAAP.  These are all successful companies. They know their margins, they know where cash is, they know their ratios and guess what, they know how to forecast!

I have also seen time and time again good companies that have been around a while and have experienced growth, and NOT prepare their financials per GAAP.  And every one of these CEO’s and companies has the exact same issues.

  • They really don’t know their margins in their P&L
  • Some companies don’t even really know their actual revenue
  • There is always that doubt in the CEO’s mind as to what is really going on in the business
  • The CEO lives a stressful life
  • Every time there is even the slightest decrease in margins, there is even a bigger disproportionate stress on cash
  • If your books are not per GAAP, then most likely they are not on the accrual basis; if that is the case, then you are 60-90 days behind your business
  • Having your books on an accrual basis is just the first step. There are many other accounting rules, procedures and pronouncements to get your books per GAAP. Just because they are on accrual basis, does not mean they are per GAAP. GAAP “rules” actually change frequently

You Can't Afford Not to Spend Money on the Accounting Department

In Summary

In my consulting business, I have seen CEOs that are “smart” as in they know what they don’t know. They bring us in to get the problem fixed. Although it takes time and money, the CEO is fully supportive and we get it done. These are the companies that grow and ultimately have a successful liquidation event. Or they leave a well-run machine to their family or employees.

But it shocks me to continue to see companies as large as $120 million in revenue, with a couple hundred employees that have not professionalized their accounting department. No one knows the true margins. Everyone stresses out about the “accounting records.” There are no correct historical financials, and most certainly, there are no forecasts. Unfortunately, there is no analysis of the business at all. In some high margin “hot” industries, this works for a while. The sins are buried. But millions of dollars are lost without knowing it. But, since ultimately everything ends up in cash, when that “hot” industry has even a slight downturn, the CEO feels the cash crunch.

Whether you are trying to increase the value of your company or positioning it for sale, this issue of unknowingly leaking cash is a destroyer. Learn how to tighten your belts and increase value with our Top 10 Destroyers of Value whitepaper.

Don’t be Cheap

Don’t be cheap. Spend the money (which is usually less than the hunting lease) to get your books and records based on GAAP basis.  Get your priorities straight.  Continue to have a professional accounting department in your business. YES, you will spend more than you are currently spending. But you can’t afford not to spend money on the accounting department!

Consider this… I had one investment banker with a very large firm tell me the difference in a valuation of an acquisition target from a company that has accounting records per GAAP and solid accounting department versus one that does not have a professional accounting department and accounting records not per GAAP is a difference of 20%-30%.  I had another investment banker tell me the difference in valuation is “one turn of EBITDA”. The use of EBITDA and multipliers is often used in valuation.

So if your company generates $2 million EBITDA and the multiple used is a 5, then your value would be $10 million with a professional accounting department and books per GAAP. In comparison, your value is $8 million with an unsophisticated accounting department and accounting records not per GAAP. I don’t think your professional accounting department will ever cost you $2 million per year! But not having it will.

Not having your financial records per GAAP is one of the destroyers of value. If you want to protect the value of your company, download the free Top 10 Destroyers of Value whitepaper to learn how to maximize your value.

You Can't Afford Not to Spend Money on the Accounting Department

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You Can't Afford Not to Spend Money on the Accounting Department

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What is GAAP?

What is GAAP?

GAAP stands for Generally Accepted Accounting Principles. It is the set of rules and guidelines for U.S. companies to follow. GAAP regulates financial reporting for public companies, private businesses, non-profits, and government authorities. This means that GAAP outlines the procedures to make sure that businesses are recording their financials in the same way.

GAAP Principles

The principles in GAAP ensure transparency and consistency. This includes the following topics:

The overall philosophy behind these principles is to prevent deceptive recording.

What is IRFS?

While the United States follows the GAAP, most of the developed world follows the International Financial Reporting Standards (IFRS.) In 2008, the United States decided to move towards adopting the IFRS to be more consistent with the rest of the world. While the long term effects are only speculative, the short term changes will have an immediate impact on accountants, managers, and investors.

IFRS vs GAAP

What is the benefit of following the same set of guidelines as the rest of the world? One major advantage of having the same international financial reporting guidelines is the effect on investors. Investors will be able to compare and contrast investments between nations more accurately.

For example, if there is one startup in the United States and one in London, then they will likely use different methods for financial reporting. This could make the investor’s decision very difficult. If inventory and depreciation are valued differently, then the investor might not fully understand the true standing of these startups.

What is GAAP

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Continuous Accounting: The New Age of Accounting

See Also:

Reducing Your Cash Conversion Cycle
Key Performance Indicators (KPI’s)
Accounting Principles 1, 2, and 3
Accounting Principles 5, 6, and 7

Continuous Accounting: The New Age of Accounting

Continuous Accounting is the new age of accounting. It provides a more efficient way to review financial performance in a real-time automated process, and a trustworthy, repeatable accounting cycle to forecast future results. It also gives the financial department a larger role in strategy and planning.

The Old Model: Record-to-Report (R2R) Accounting

The traditional model consists of a linear record-to-report process for accounting. In order to complete a record keeping process, a company must report certain tasks and responsibilities pertaining to the company’s financials. Expect these to be completed by the end of the period – which can last anywhere from two weeks to two months. Store and manage the data in a large computer processor. Disadvantages of this process include:

  1. The data accumulated over a large period of time have a greater chance for error with unreconciled transactions
  2. Inaccuracy and misrepresentation
  3. Takes up too much time and loses effectiveness of team

The New ModelFinancial Strategies with Cloud-Based Technology

Managers and financial leaders cannot afford to wait a month to two months for reports to be processed. This is what bookkeepers tend to do. Continuous accounting changes the prolonging process from period-end to a day-to-day basis. The cloud platform is capable of recognizing and verifying information constantly and repeatedly, thus enabling it to be “continuous.”  This evenly distributes work rather than accumulating large amounts of tasks over time. Continuous accounting is an organized alternative to the old model of record-to-report accounting.

Shifting Business to the Continuous Accounting Platform

In the past, bookkeepers would record with accumulated reports, which would process a month at a time at least. With the matching principle, the company matches the expenses that are incurred during the same period the revenue is recognized (or the time the service was performed). Instead of recording in batches, modify the accounting system record as they occurred. Now, the next progression is to continuously reconcile accounts and analyze detail. In order to do this, have companies automate their systems. Otherwise, bank statements and other records would have to be linked and reconciled daily.

The New Age of Accounting

Advantages of Continuous Accounting

1. Continuous Accounting processes financial information faster than before.

Certain companies depend on a faster cash conversion cycle, in which case this technology would be useful. Instead of reviewing financial information every month or so, continuous accounting will complete the processes day-by-day. The processing of financial information will be quicker, and key performance indicators will become more apparent and easier to fix. This allows financial leaders to eliminate risk and take action proactively and defensively.

2. Automated systems improve the productivity of the accounting departments.

Increased automation should result in the benefit of improved productivity. This reduces costs because taking the manual systems, rather than automatically through continuous accounting, and applying them everyday would be cost-prohibitive.

(Want free access to a tool that can measure your unit economics? Get it here!)

Disadvantages of Continuous Accounting

1. Adapting the finance departments to a new way of accounting.

Implementing change is always a challenge, especially when a department, trained for 10, 20, 3o years on how to properly perform accounting, does it. Larger companies would benefit from continuous accounting more than smaller companies, where new, younger, more adaptable people work. However, the disadvantage of switching from traditional accounting to this new automated technology is that the larger companies have employees that have worked as an accountant for 25+ years and aren’t as adaptable.

2. Financial statements may not be as accurate. 

Instead of waiting a couple of weeks before submitting invoices or reports, continuous accounting processes the information right away. This leaves little time to adjust and organize data. By using continuous accounting, the financial leader succumbs to having financial statements 90% accurate rather than the expected 100%.

How Continuous Accounting Affects the Future of Finance

Technology itself is changing finance departments globally. Continuous Accounting is just the start of new automation processes that pertain to large sources of data. Technology such as Continuous Accounting establishes a precedent for timely, cost-effective, and/or high-quality improvements for business.

New Age of Accounting, continuous accounting

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New Age of Accounting, continuous accounting

 

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Case Study: Pricing for Profit

Several years ago, I was consulting with a client in the staffing industry that was having a profitability problem:

We have happy customers and seem to be doing well, but we just aren’t making more money

Sound familiar?

After visiting with the frustrated owner of the business, I visited various departments to understand the people and processes behind the numbers.

Operations

My first stop was at the operations department to learn about how the jobs were staffed.  I found out that on any given job, the company utilized both 1099 employees and W2 employees.  I asked them if they had the ability to track which type of employee worked on which job and they let me know that they could.

(Intuit offers a great visual aid on the difference between 1099 and W2 workers here).

Sales

Next, I met with the sales department to determine how they were setting prices.  I learned that they priced their services on a cost-plus basis using a markup of between 30% and 50%.

Their sales force also related to me that they were constantly being beaten up on price by their customers.

Accounting

My last stop was to the accounting department to see what the financial statements could tell me about the company’s lackluster profitability.  Among other things, I found that overhead was running 20%-25%.

Findings

Based upon all of my investigating and conversations with the various departments within the company, I found several issues:

Additional costs were not reflected in price.

The type of employee that would be used on the job (1099 vs. W2) was not taken into account when the job was bid.  Consequently, the additional cost of the payroll taxes for using W2 employees was not being captured in the price.

Margin and markup were used interchangeably.

The sales department had assumed a 30%-50% markup was the same as a 30%-50% margin when setting prices.  Further, they did not understand the impact this confusion had on profitability.

margin does not equal markup

(See Margin vs. Markup for further explanation of the difference).

Overhead couldn’t be covered.

The current pricing structure was not sufficient to cover the company’s overhead and still allow for a profit.

The answer seemed simple; the company had a pricing problem.

The wrinkle was that the sales force was already feeling great pressure to keep prices low in order to keep their customers, and didn’t have the confidence to approach them about a price increase.

Solution

My solution was to put together a communication tool for the sales force.  The tool was nothing more than a spreadsheet that broke out all the costs associated with delivering the service down to net income.

But its real value was in the confidence that it gave the sales people.  Not only did it allow them to understand what it would take to make a sale profitable, it gave them…

  1. A justification to go to their customers and ask for a nominal 1%-2% increase in price
  2. A working bid model for new customers

Takeaway

In a situation such as this one, it’s easy to default to the old & trusty fix: Reduce overhead. Cut costs.

But this is where the rubber meets the road in being a financial leader or CFO. The problem is so often more complex than large expense accounts on the P&L. You must interact with various departments, think critically and problem solve.

Identifying opportunities like those detailed above comes more naturally after years of experience, but these skills can also be acquired through training. Check out our Financial Leadership Workshop Series if you or someone in your company is eager to learn and develop.

Act!

Are you in the same boat as our client? Does it feel as though you should be making more money than you are? Download our Pricing for Profit Inspection Guide below.

pricing for profit

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pricing for profit

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Debit vs Credit

Debit vs Credit

Since the late 13th century, people have discussed debit vs credit. Double entry accounting was conceived centuries ago. Now, it is an international standard to record all business transactions with a debit and a credit. This double entry keeps the accounting equation balanced. It also ensures that one account is not left out of a transaction. If you make a mistake, an unbalanced ledger occurs.

Should You Learn It?

Even though accounting software guides you along the double entry process, it is still important to understand the debit and credit rules. This gives you the ability to correct mistakes and edit your company’s books. Without knowing the fundamentals of double entry accounting, you run the risk of keeping inaccurate records that may be beyond repair.

Entrepreneurs are often guilty of not truly understanding accounting and their company’s financial statements. Understanding these begins with grasping the debit and credit rules. These rules are part of a bigger concept: keeping the assets equal to the liabilities plus shareholders’ equity.

What are the rules?

The basic rules state whether an account increase or decreases with a debit or credit. Asset accounts and expense accounts increase with debits and decrease with credits. This means you debit cash to increase the cash account. It also means you debit your COGS to increase your cost of goods account. On the other hand, liabilities, revenues, and shareholders’ equity increase with credits and decrease with debits.

While these rules are not instinctual, they helped businesses keep accurate records for centuries. The extra work to record a debit and credit for each transaction helps prevent errors as well as making mistakes easier to identify.

If you want to add more value to your organization, then click here to download the Know Your Economics Worksheet.

Debit vs Credit

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

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Debit vs Credit

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