Cash vs. Accrual Based Accounting…. What does it mean to the Small Business Owner?
In my opinion, one of QuickBooks’ best features is its ability to run financial reports, like a Profit and Loss, on both a Cash and Accrual Basis. But I am often asked by my clients “What does that mean? What is Cash vs. Accrual?”. I’ll try to answer that question here on a level that applies to the Small Business Owner evaluating his or her Profit and Loss Report and Balance Sheet. I’ll try to leave out the accountant-speak and technicalities.
Your Profit and Loss Report is a snapshot of your business’ income and expenses for a specified period of time. Your Balance Sheet report is basically a report of what you own, what you owe, and your business’ Equity (the difference between what you own and what you owe) as of a certain date.
Let’s talk about Accrual basis first.
When you are looking at your Profit and Loss report on an Accrual basis,
- Your income will include everything you billed customers for during that time period, whether or not you have been paid by those customers.
- Your expenses will include bills from vendors that you have entered into QuickBooks for a that time period, whether you have paid the bills or not.
On an Accrual Basis, the Balance Sheet report will include:
- What is owed to you (customer invoices, called Accounts Receivable)
- And what you owe (outstanding bills to your vendors, called Accounts Payable).
In order to achieve good Accrual-based reports in QuickBooks, you need to use the Customer Invoicing and Enter/Pay Bills features. It’s also a good idea to pay attention to the dates you bill your customers and bills you enter from your vendors, to be sure they are posted in the period they were incurred.
Most small businesses file their taxes on a Cash Basis, so why would you want to evaluate your finances on an Accrual basis? I ALWAYS recommend evaluating your business’ financial performance on an accrual basis at least monthly, because what you have collected from your Customers and what bills you have paid aren’t necessarily indicitive of your business’ earnings performance.
In fact, many businesses will show a profit on their Cash Basis Profit and Loss Report right until the day they go out of business! Because if you don’t show an expense when it’s incurred, but when it is paid (like on a Cash Basis, which we will talk more about in a minute), your expenses are understated.
Let’s look at a professional services business like mine, for instance. First of all, we bill many of our clients on an hourly basis, so I make sure to bill out as much time as possible on the last day of the month. That way, when I run our Profit and Loss Statement, I can see what we earned that month, not necessarily what we collected, but what we earned.
Like any business should, we know what we need to earn every month to break even. I may have cash in the bank because I haven’t paid all the bills yet, or because I collected on some old invoices from customers, but that doesn’t necessarily mean that our business has performed as it should.
Income is the largest consideration in our business, but it holds true with expenses as well. Expenses should be entered into QuickBooks as Bills for the date they are incurred. That way your Accrual-based Net Income (Income less Expenses) for the period you are evaluating is a true indicator of your performance for that time period. Did you spend more than you earned for that period? If so, it may take a month or two to catch up to you, and you want to be prepared. Are you showing consistent earnings yet your cash flow is suffering? You may have an issue with collecting on outstanding invoices from customers.
So what good are Cash basis reports? For one thing, many businesses file their taxes on a Cash basis, so you want to keep on top of what your income is going to look like for tax purposes. Cash basis reports are also more closely tied to your business’ cash flow. When you look at a Profit and Loss Report on a Cash basis, you are only going to see Income from customers that you have actually received in your hot little hands. You will only see expenses for things that you have actually paid. If your business operates on a cash basis – meaning you pay for your business expenses as you incurr them and collect money from your customers on the spot, your Cash basis and Accrual basis reports will be the same.
In QuickBooks, you can easily run Cash and Accrual Based Financial Reports, click here for a quick interactive video lesson: QuickBooks Switch From Accrual to Cash Basis Report
Even with this information, financial reports can be confusing! The larger the business, the more complex the financial evaluation should be. There are many other aspects of your finances you need to evaluate, like the return on investment of your assets. Your industry may also require special attention to one or more aspects of your financial situation. Intelligent, competent, business professionals sometimes feel uncomfortable asking for assistance evaluating their finances. Don’t feel like you should know this stuff instinctively! Just like anything, it takes patience, practice and often professional help to understand. There are, of course, many books on the subject, as well as the occasional seminar. Don’t be afraid to seek assistance from your bookkeeper (they may know more than you think, but you just never asked!), your CPA, or a business coach.