The Most Misunderstood Thing in Business
Cash versus Accrual Accounting – Why You Need to Know
There are two different accounting methods to report income and expenses. One is called the CASH basis, which tracks cash as it comes in, and expenses as they are paid. The other method is called the ACCRUAL method, and it is based on when the work is completed and billed. Income is counted when it is earned, and expenses are recorded when they are incurred to produce that billing. Accrual is regardless of when you actually pay the bill or pay the invoice.
Cash accounting – This method keeps track of money only when it actually moves. You count income when you get paid, and expenses when you pay the bill. It’s like balancing your checkbook.
Accrual accounting – This method focuses on when the work is done, not when the money changes hands. You count income when you send the invoice (even if you haven’t been paid yet), and you count expenses when you receive a bill (even if you haven’t paid it yet).
You performed work to be billed and created expenses to do that, regardless of when or even if, it is paid. The easiest way to understand this, is when you begin to work this month, you are creating bills in order to be able to generate that work. For example, labor, material, rent, utilities etc. Even though you aren’t paying those today, they are costs created in order to produce your service or product in that month, regardless of the volume of work you produce. When you bill for that service or product, you know how much you billed that month compared to how much you theoretically will have spent to be open in order to be able to produce those invoices.
In Cash accounting, you can go for 3 months and not pay bills. You can therefore say that anything you did collect for, had no expense to produce it because they weren’t paid for yet. This means you could bill and collect the cash quickly in say 10 days, and not pay your expenses or just part of them, for 2 or 3 months, On paper that would make it look like you made money, but in practice, if you collected $50,000, but only paid $40,000 of expenses even though this work created expenses of $60,000, it would look like you made $10,000 instead of actually losing $20,000. A cash basis can show month after month that your income exceeds your expenses and you’re making money, but only because the bills you can’t pay don’t get accounted for on the income statement and the excess that you can’t pay just keeps piling up.
For a real time handle on where your costs are in order to produce the billing for a given month, you need to always track your finances by the accrual basis of accounting. The only way to know if your costs to produce work in that same amount of time are in line with each other, is by the accrual method.
I have seen many Income Statements (P&Ls) that were marked as accrual, but didn’t have repeating monthly expenses showing up every month, for example Rent. Rent typically happens every month, whether we do any work or billing. It should show up as an expense on an accrual basis, but I have seen many occasions where one month shows no rent and the next shows double the rent. This is because they couldn’t or didn’t pay rent the first month and paid two months the following month to catch up. This is the Cash basis of accounting, not accrual.
Now You Know!
