Over the years, Preferred CFO has collaborated with a myriad of enterprises. These range from fledgling startups and modest ventures to mid-sized entities or those seeking capital influx. A substantial number of these firms are witnessing robust expansion. Many others have yet to reach a stage where a full-time, in-house CFO is justifiable or financially viable. One of the initial considerations we tackle with these enterprises is their accounting methodology. This includes choosing between cash basis accounting and accrual basis accounting
Most nascent businesses adopt cash basis accounting, and the rationale is evident. This accounting technique is not only simpler to implement and oversee, but it also provides bootstrap (or financially constrained) businesses with a quicker, more straightforward snapshot of their current cash status.
Nonetheless, as a business progresses, it errs significantly if it fails to transition to accrual basis accounting.
Why Should You Care About Accrual Basis Accounting?
When we broach the subject of accrual basis accounting, the eyes of founders and CEOs often glaze over. Why compare one accounting method against another (yawn) when the current method seems satisfactory? Because cash basis accounting offers a restricted perspective on financial transactions. Additionally, it does not conform to GAAP standards.
GAAP (Generally Accepted Accounting Principles) constitutes the standard framework of regulations and guidelines that accountants must adhere to when preparing a business’s financial statements in the United States. According to these standards, any company with sales exceeding $25 million must employ the accrual method for bookkeeping and reporting financial performance. Thus, if your business anticipates surpassing $25M in sales, updating your accounting practices becomes imperative.
Do you foresee your business potentially exceeding $25M in sales shortly? Then you should consider adopting the accrual accounting method when setting up your accounting system. $25M might appear an ambitious target for some companies. But if you anticipate growth, why not align your financial statements with prevailing requirements?
Cash Basis Accounting vs. Accrual Basis Accounting
What distinguishes cash basis accounting from accrual basis accounting? Why is transitioning so crucial for companies with growth aspirations?
Accrual basis accounting entails calculating revenues and expenses as they accrue. This means revenues are recorded when the sale is made, even if payment is pending. Expenses are recorded when the purchase is made or the bill is received, irrespective of payment status.
Conversely, cash basis accounting records transactions only when the money changes hands. This means a sale is recorded when the payment is received, not when the sale is made. Similarly, expenses are recorded when the bill is paid, not when it is received.
Furthermore, cash basis accounting does not track long-term liabilities, loans, or inventory. Nor does it require maintaining records of specific sale or purchase dates. In other words, there are no records of accounts receivable or accounts payable, which can complicate matters when immediate payment is not received or bills remain outstanding.
Why Bother with Making the Switch?
The primary advantage of shifting to accrual basis accounting from cash basis is transitioning from “hoping for the best” to establishing a robust, forward-looking financial plan.
Cash basis accounting is akin to living from paycheck to paycheck. Even with budgeting in place, you likely rely heavily on the current bank balance and financial statements to manage finances.
This accounting method can be detrimental as it fails to provide an accurate, realistic view of the company’s financial health.
For instance, you may have several unpaid bills and invoices that make your cash situation appear favorable when, in reality, your financial position might be precarious once invoices or other obligations become due.
Accrual basis accounting equips you with more information and a more accurate overview of your business. It reveals not only the cash that has changed hands but also the expected cash, upcoming expenses, and the overall health of your company.
Powering a Forward-Looking Strategy
Unlike cash accounting, which offers a short-term view of a company’s financial status, accrual accounting provides a long-term perspective on the company’s performance. This is because accrual accounting accurately reflects the money earned and spent within a specific period. This provides a clearer indication of business trends over a quarter or a year. Additionally, it adheres to nationally accepted accounting standards, ensuring that the accounting method remains consistent as the business grows.
Sales terms—both for expenses and revenues—vary. With cash basis accounting, revenue or expense may not be recorded for weeks or months after it occurs. In some instances, the cash exchange might not even happen within the same fiscal year as the transaction.
However, with accrual basis accounting, expenses and revenues are recorded at the time they are incurred. This matching principle is a fundamental aspect of accrual accounting. In accrual accounting, revenue is recorded as soon as it is earned, regardless of when payment is received. The matching principle then requires that all expenses related to generating that revenue be recorded simultaneously. This enables decision-makers to assess project profitability more swiftly and accurately.
One of the many benefits of accrual-based accounting is that it aids in forecasting, budgeting, and developing sales strategies. Although this method demands more intensive bookkeeping, it provides business owners with a more realistic understanding of income and expenses during a specific period.
This comprehensive view allows you (and your accountant) to better comprehend consumer spending patterns and plan more effectively for peak operational months. With precise accrual data, a company can more accurately track sales trends, seasonality, expense patterns, and more. This is especially beneficial for forward-looking financial strategies that utilize data and projections to develop forecasts for the next 1-5 years.
Final Thoughts: Don’t Fight It
Some companies using cash basis accounting resist transitioning to accrual basis accounting because they are accustomed to a retrospective accounting system. This system shows where they are now and where they have been. However, it does not account for more than what is tangibly in their accounts. Transitioning to accrual accounting means adopting a forward-facing financial strategy, offering a view not only of past and present but also future financial health.
For those contemplating the transition, it may seem daunting or unnecessary. But once you make the switch, the benefits and enhanced decision-making capabilities become evident. Accrual basis accounting provides a comprehensive, informed view of your company’s health, enabling the design and execution of more sophisticated and successful strategies for the future.
If you need help switching accounting methods or with other financial issues, we encourage you to check out the services offered by Preferred CFO. Sign up for a complimentary consultation today!
