At Third Road Management we have the honor of working with businesses and non-profits across a spectrum of industries, ownership structures, tenure and financial status. Through our experience we have gathered some wisdom that can hopefully be helpful to business leaders outside of our current network of clients. This is our venue to share some of our ideas.
Simply stated, the best way to think about cash basis accounting is “money in = revenue” and “money out = expense.” Almost all organizations commence their accounting utilizing this methodology for a few reasons:
- It’s easier.
- It makes reconciling to bank accounts more straight forward.
- Most people pay taxes on a cash basis and that is how your tax accountant likes to receive financial statements.
There are some significant disadvantages to cash basis accounting, however. Here are a few of note…
- Because cash basis accounting does not reflect revenue “when earned” and expenses “when incurred”, cash basis statements generally are not fully reflective of the true financial performance of the organization. In other words, your bottom line may be artificially too high or too low, and that doesn’t make decision making easy.
- Cash basis financial statements can be very lumpy, making the statements very difficult to interpret. For example, let’s say a customer paid up-front for an entire year’s worth of product or services. The cash basis of accounting would show all of that income in a specific month whereas accrual based accounting would recognize that income “when earned” or, for the sake of simplicity for this example, equally each month over a 12 month period of time. Because of this lumpiness, many leaders and owners of businesses that utilize the cash basis of accounting struggle to find meaningful interpretations of their financial statements.
Eventually these disadvantages become increasingly pronounced and organizations rightfully shift to accrual or modified cash basis accounting. In the interest of clarity, unless an organization wants or has to, we are not suggesting that they need to adopt full GAAP (Generally Accepted Accounting Principals adopted by the Securities and Exchange Commission). Rather, we are are suggesting that they move in the direction of adopting at least some accrual based principals to help provide more critical insight into the organization.
So, here’s the purpose of this blog. If your organization has not yet adopted any accrual based accounting methods, and as a result you are not receiving meaningful business insights, we strongly encourage you to consider a shift in practices. You’ll be very thankful that you did and benefit from:
- P&L statements that more accurately reflect true revenues, expenses and income.
- A balance sheet that accounts for all assets and liabilities ensuring that your net assets aren’t overstated or understated, and
- A statement of cash flows that accurately factors in long-term investing and financing activities.
As for your tax accountant, don’t worry that too much as converting between cash and accrual basis statements can be fairly straightforward at year end.
At Third Road Management our expertise lies in everything helping you lead strategically, financially and operationally, including the adoption and management of accrual based accounting practices. If you need any help always feel free to contact us at firstname.lastname@example.org for a no-obligation initial consultation.