This series will address the principles of accounting with which every small business owner must be familiar. Trust me, we do not want to put you to sleep with accounting . . . you are an entrepreneur not an accountant. Unless you are an accountant, them I’m just kidding . . . accountants rock!
The idea here is that even if you hire a book keeper and/or CPA to handle your financial records, we want you to be familiar with the most basic of accounting principles so you are not blindly accepting the records that are created for you.
We will start today by describing the difference between “cash” and “accrual” accounting. In all likelihood, unless you direct your book keeper differently, he will provide you two sets of financial statements – one using “cash” accounting principles and the other using “accrual”. You need to understand the difference.
Cash accounting is the more intuitive of the two versions. Cash accounting is the process we use at home to balance our checkbook. Cash comes in, cash comes out . . . and we capture those transactions as they occur. This may work out fine for your personal budget, but it rarely works for business accounting in the long run and here is why:
Imagine that your business produced a net profit of $100k in its first year of operations (not bad . .well done). In your second year, business continues to improve and you are on track to DOUBLE your profit to $200k. Wow! However, because business is growing so rapidly and you see no end in sight to the expansion, you invest in all new equipment for your business and you spend $100k doing so. This new equipment will serve your customers and generate revenue for the next 10 years. If you expensed the purchase of this investment in one chunk of $100k (as you would in your personal finances), at the end of the year your records would reflect an income of $100k. To an outside observer – a bank loan officer, a potential partner, a potential investor or buyer – your bottom-line would indicate that your business is FLAT and not expanding rapidly. Of course, in the simple example that I provided, the situation would be easy to explain; however, as your business grows and the manner in which your revenue, expenses and investments are conducted, this process can become overly complex very quickly.
The alternative? Accrual accounting. Accrual accounting takes “credit” for revenue and deducts “expenses” in a manner that more accurately reflects when and over what period the services provided or acquired are used.
In the above example, accrual accounting would expense $10k each year in the category of “depreciation” and repeat this process for ten years. Your expectation is that the equipment will generate revenue for 10 years, so we will expense that the purchase price in 10 even parts over that 10-year period.
Now, your end of the year bottom-line would indicate a net income of $190k . . and provide a truer reflection of the year’s business.
The same is true on the revenue side. If one of your client’s pays your company $50k for five months worth of work, that revenue, when using accrual accounting would be split into five equal parts and then added to the books as $10k of revenue per month for the five months that you provided your company’s services.
BEWARE: Not a topic for today, but for those of you who may dabble in the stock market and review the financials of public companies to assess their performance. Accrual accounting is at the “heart” of the voodoo accounting that can be performed by an unscrupulous provider. As it does not actually capture “cash”, accrual accounting is capable of creating abstract art passed off as financial statements.
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