Cash vs. Accrual: A Critical Lesson of the First Week

Annie and I were in a cash accumulation mode last year, if not quite awash in it (at least compared, say, to when we got out of grad school). By selling our summer home in Maine after 40 years, cashing social security checks, and beginning to take minimum required distributions from our deferred-income accounts, we zeroed out our remaining debt. It was all good for the bank accounts, if not for minimizing taxes.

However, in pulling together all of our 2012 tax-related information during the past couple of weekends, I realized that I didn’t have more than just a sense of how the financial part of my company, Financial Managers, was doing. I have not lacked for interesting opportunities with clients, and their checks flow steadily into my post office box, but the Current Balance in the company checkbook doesn’t tell the whole story.

Without divulging trade secrets (right!), I will acknowledge that for a one-person operation, my company checking account offers a number of useful attributes, not least of which is that the bank that’s behind it knows my name, we have a 30-year history together, it provides on-line service, and it doesn’t discriminate between personal and professional receipts and disbursements. That’s my job, to sort things out, usually in the two weeks prior to Tax Day.

But the goal of the Big Sort isn’t just to determine whether I’m a creditor or a debtor with the IRS, it’s to tell me how much of a profit Financial Managers made last year after my salary, benefits, and business-related expenses. I know how much cash I had at year-end vs. what I had at the start, and I can easily calculate the difference. That’s cash-basis accounting, straight from my checkbook. But what I really want to know is how much profit the Company earned on the services that I provided from January 1 through December 31. That’s accrual-basis accounting, and it doesn’t matter, for example, whether or not I took those checks from the p.o. box to deposit in the bank, or if I actually got paid all of the salary that I earned during 2012.

For my company, it’s mostly an academic exercise to match revenues earned with related expenses incurred during the same period (which is the definition of accrual accounting for you academics). For you practitioners, once you start having products or employees, it’s real. Consider:

  • One of my first clients, 30 years ago, was a respected monthly professional journal that spent its subscribers’ fees almost as fast as it received them. With a renewal rate above 90%, they could rely on their projected receipts to generate cash, but only 1/12 of the subscription fee was supposed to be booked as revenue each month of the subscription term. This meant that with every subscription they should have recorded a liability to cover the following 12 months of publication. Didn’t happen. Instead, when they considered selling the company, they realized that they had to absorb a double hit – they had a large liability for unfulfilled subscriptions and, on an accrual basis, they had been spending more money than they were earning. Cash-basis accounting had lulled them into thinking that they were generating a profit.
  • More recently, a services company that I’ve been working with has had month-to-month swings in profitability despite a consistent flow of business and steady, predictable overhead expenses. A scan of their income statement revealed that their payroll expense varied by as much as 50% each month: as a result of their bi-weekly payroll policy, there were two months every year in which they had to absorb three payrolls instead of just two. A more accurate reading of monthly profit resulted when they started allocating their payroll expense proportionate to the number of work days in each month, following accrual-based accounting procedures.
  • Owners and managers of all stripes have a hard time believing their financial statements when:
  • A big annual insurance bill gets fully booked in the month it was received rather than being spread out over the 12 months of coverage;
  • The rent expense is double what it should be because it was paid on the 1st and 30th of the month (for the next month);
  • The revenue for the product that was shipped this month was recognized this month, but the related expense was incurred and booked last month;
  • A 40% deposit received for a six-month service project was all booked in month one, even though the project payroll will be incurred evenly during the life of the contract;
  • Year-end adjustments include significant write-downs of the value of obsolete inventory and write-offs of delinquent accounts receivable that should have been provided for by booking reserves each month for these likely occurrences;
  • The major expense of the company’s annual trade show is recognized on the books in the month that it happens instead of spreading the impact over the next 6-12 months when the benefit to revenue likely will be realized.

Smaller companies have become victims of the simplicity of accounting software packages. It’s easy to book revenues and expenses in QuickBooks, for example, and there’s even a toggle switch to go from a cash to an accrual presentation of the financial statements. But, as indicated above, there are some subtleties that require what’s known as adjusting entries in order to avoid management comments like “Well, we know last month’s bottom line wasn’t as bad is it shows because we didn’t actually send invoices until this month on the big project that we spent so much time on.” Or, “We have a lot of commission expense that’s not on the books because it’s not payable to the sales team until the customer’s payment is received. The CPA will true it up at the end of the year, and we’ll take a big expense hit in December.”

Here’s the question to ask your accounting team: “Tell me how you provide for the differences between cash and accrual accounting in the financial statements that you produce for us.” Even if you’re awash in cash, if your accounting person’s response doesn’t bear some relationship to the examples above, you might suggest that he or she review a critical lesson of the first week in Accounting 101.