An Often Overlooked But Importance Decision
As an entrepreneur, you are constantly faced with dozens of important decisions, from determining the right strategic direction of your company, to recruiting and training employees, to ensuring customers are succeeding with your product or service. You make consequential decisions every day. Don't overlook the importance of your accounting method choice, as many business owners do.
There are two main accounting methods that business owners utilize: cash and accrual. Each method has different principles that guide revenue and expense reporting. In this article, we’ll cover the basics of cash and accrual accounting, including which method shines when it comes to valuations and making strong operating decisions.
What is Cash Accounting?
The cash basis of accounting records transactions when cash is paid or received. The accounting for cash basis businesses is straightforward, as the checking account dictates the timing of transactions. Schedule C taxpayers, which are generally sole proprietors, and single-member LLCs will use the cash basis of accounting for tax reporting.
However, cash accounting is not an accepted accounting method under Generally Accepted Accounting Principles. If you have lenders, investors, and other third parties asking for GAAP-compliant financial statements, you will need to consider accrual accounting.
What is Accrual Accounting?
The accrual basis of accounting recognizes transactions based on contractual obligations. This means that no cash transaction needs to take place before items are recorded in your financial statements.
Instead, accrual accounting records transactions once certain criteria are met (see below for details). This leads to the utilization of payable, receivable, deferred, and prepaid accounts on the balance sheet. Accrual accounting is an accepted method under GAAP, making it beneficial for companies that need to distribute compliant financial statements.
In addition, accrual accounting is required for certain taxpayers, such as those that have average revenue in excess of $25 million over a three-year period and some manufacturers.
How are Revenue and Expenses Impacted Under Cash and Accrual Accounting?
There are timing differences between cash and accrual accounting, which can lead to overstating or understating net income in any given period.
Revenue
Cash accounting only recognizes revenue once cash is received, while accrual accounting follows ASC 606. Under ASC 606, businesses will recognize revenue once the contractual obligation is satisfied using the following five-step process:
Identify the contract with a customer.
Identify each performance obligation (i.e. manufacturing, installation, service).
Determine the transaction price.
Allocate the transaction price to each performance obligation.
Recognize revenue once each performance obligation is satisfied.
Strategic recognition of revenue under accrual accounting leads to more transparency. If a customer pays upfront before any work is completed, your company has not earned that revenue yet. However, under cash accounting, the deposit would be included in revenue, while accrual accounting defers consideration until performance obligations are satisfied.
Differences in revenue recognition are especially apparent around year-end. If you bill a customer $100,000 on December 31, but the invoice is not paid until January 1, revenue could significantly differ under each method.
Expenses
The recognition of expenses also has discrepancies between cash and accrual accounting. Like revenue, recording expenses under cash accounting depends on when cash leaves the checking account.
For example, if your company prepays a full year of insurance, you will immediately expense the amount to the income statement under the cash basis of accounting. Under accrual accounting, you would need to record a prepaid expense on the balance sheet and expense a portion each month.
Accrual accounting utilizes the matching principle for expense recording. Under the matching principle, expenses related to revenue must be expensed in the same period that revenue is recorded. The matching principle most commonly comes into play with cost of goods sold and inventory.
The expenses that are related to a specific project or invoice will be moved from inventory to cost of goods sold once revenue is recognized. This ensures that inventory and net income aren’t overstated on the financials.
Why is the Accrual Basis of Accounting Important in Valuations?
Accrual accounting is the choice for most business owners because of added transparency and comparability. When it comes to company valuations, one of the primary methods is comparison to other public companies.
All public companies are required to use accrual accounting when issuing financial statements. If your company is operating using cash accounting, it can be difficult, if not impossible, to make accurate comparisons.
Cash basis statements that don’t properly time expenses can lead to overstated expenses or understated revenue, resulting in a poor comparison to actual results. The same is true for understated expenses and overstated revenue, indicating unrealistic operational efficiency.
Margins, growth rates, KPIs, and industry benchmarks all utilize accrual accounting. If you are looking to sell your company in the near future, you need to be tracking all of these factors to maximize your valuation. Cash basis accounting doesn’t produce accurate financials to base these factors on, which is why accrual accounting is the preferred method.
Why is Accrual Accounting Important for Making Strong Operating Decisions?
Strong operating decisions are the foundation for success and scalability. How will you know when it’s time to expand or how profitable jobs are if you aren’t using an accounting method that prioritizes the matching principle?
Determining operating margins, comparing growth to industry standards, and planning resources all depend on evaluating operating results that accurately display your company’s financial position.
Moreover, businesses can obscure returns on investments based on inaccurate income statement creation with cash accounting. Deferring a large expense until after year-end or pushing through a receivable for an upcoming project can significantly impact financial results. This can lead to decisions made based on inaccurate financial information.
Concluding on Accounting Method
Are you using the right accounting method? Cash and accrual accounting have distinct timing differences, which can impact your valuation, financials, and decision-making process. Although you have no shortage of decisions to make as a business owner, your accounting method deserves to be prioritized. If you are preparing your business for a sale in the near future, it’s important that you choose the accounting method that generates accuracy, transparency, and trust.
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