CFO for Hire Secret Weapon — Accrual Basis Accounting vs a Tax Accountant’s Cash Basis
You’ve probably already found out as a business owner that accounting can be complex. This article will break down the value of a CFO for Hire from the perspective of accrual vs cash basis accounting, and why tax accountants prefer cash basis.
Unfortunately, there are essentially two schools of thought when it comes to accounting, and this article is going to explain the benefits of each, who uses each, and give you some suggestions in selecting which you should use in your business. These schools of thought are each called a basis.
Definitions of Cash Basis and Accrual Basis
The basis (underlying, guiding accounting principles) that governs the timing of your business’s transactions can make a huge difference to the way that you understand your business. Especially its profitability.
For some quick definitions:
- Cash basis means that you record transactions when cash is received or paid, regardless of when work is actually performed or goods sent/received.
- Accrual basis seeks to better match the incurring of costs or recognition of revenue to the time when goods or services are actually rendered or received.
Let’s illustrate an example where one basis’s outcome might be different from the other:
- Let’s say your business builds things. Could be websites, buildings, or custom furniture. You think you run a pretty good business model where you charge 50% of your price up-front, and 50% at the completion of the project. And let’s say that your project takes 6 months to complete.
- With cash basis, you would recognize revenue in your first and last month on the project, and losses each month in between due to expenses incurred such as payroll and product cost.
- With accrual basis, you would likely recognize an equal amount of revenue each month that you work on the project until the project is complete, and recognize the expenses as incurred each month.
With this example, you can see that with cash basis you are essentially following the flow of cash to record revenue and determine profit and loss. Unfortunately this gives you distorted view as you would only recognize revenue in the first and last month, as those are the only two months you received cash.
Accrual basis in this case does a better job of helping you see that you are earning revenue each month that you work on the project, and your profit would be a little easier to determine each month. In fact, you would show a more accurate profit or loss each month you work on the project.
From this example it is clear that for a more informed picture of what’s happening in your business, accrual basis would be better. Unfortunately, as with all higher quality products, producing an accrual basis accounting system is more challenging than cash basis. For example, accrual basis introduces Accounts Receivables and Accounts Payables – items that you don’t worry about with cash basis.
Additionally, cash basis accounting makes planning cash expenditures and creating cash projections a little easier for someone not trained in accounting. Since cash basis accounting follows the flow of cash, knowing when cash is coming in and out is very straightforward. With accrual basis, a statement of cash flows with forecasting is needed to follow the flow of cash.
With the right skilled professionals, accrual basis accounting can be very easy to understand. Accrual basis accounting can provide more insightful information regarding profitability, revenue, and expenses. Generally, as businesses grow, they convert to accrual basis accounting because of the improved value of the financial information. Key to note is that dealing with Accounts Receivables, Accounts Payables, and Statements of Cash Flows are not for the untrained; companies hire qualified and experienced staff to handle these issues.
CFO for Hire vs Tax Accountant
Who better to help a small company through this transition than a top-notch CFO? Chief Financial Officers generally have years of experience with accrual basis accounting, and a CFO for Hire who has experience with small businesses will be very familiar with the process of transitioning a company from cash to accrual basis. They prefer accrual basis because their role as CFO is to help provide strategic insight into decision making for the business.
But why on earth does your tax accountant suggest that you continue to use cash basis? Because tax laws for smaller companies generally adhere closer to cash basis accounting rules than accrual basis. It’s largely because of the IRS’s influence that tax accountants, especially accountants that offer bookkeeping services, generally prefer cash basis accounting for the bookkeeping services that they offer. But the thing to remember is that for managing your business, you’ll want to keep your books with accrual. Depending on your size, the IRS will dictate how your tax books will be kept, either accrual or cash basis.
To be fair, not all tax accountants promote only cash basis for small businesses. Some understand and promote the value of accrual. Nevertheless, they likely don’t have the 20+ years experience that a CFO has in managing and leading companies.
Preferred CFO, based in Utah, services all of its clients on an accrual basis. Its clients are better able to understand the true economics of their business and able to make strategic decisions because of their insights into the profitability of their business. Preferred CFO handles all of the complex issues surrounding the timing of revenue and expenses, and the forecasting and projecting of cash.