For many small businesses, accounting is an afterthought. The time and energy to launch a business is extensive and accounting is often just the byproduct of that energy. As a result, many small businesses utilize the cash-basis method of accounting due to its simplicity of recording revenue and expenses when cash is transferred. Although simple, the cash-basis method of accounting is not in accordance with Generally Accepted Accounting Principles and is not the most accurate representation of a company’s performance.
Although cash-basis accounting is an acceptable form of recording financial transactions, it is typically only used by small businesses due to its simplicity and alignment with the goal of providing the data needed for a tax return. In cash-basis accounting, revenue is booked when money is received, and expenses are recognized when money is paid. Therefore, if a company receives or makes an upfront payment related to services rendered throughout the year, cash-basis accounting recognizes revenue/expense for the payment in the period received or paid. Although this approximates cash flow, it creates a potentially misleading financial reporting scenario where some periods look extremely profitable while other periods look unprofitable.
As small businesses mature, there is often need to graduate from cash-basis accounting to accrual-basis. The accrual-basis of accounting recognizes revenue as it is earned and matches expenses with their associated revenue which presents a more accurate picture of the company’s financial and operational performance in each month. For this reason, many lenders, investors, and stakeholders will insist on accrual-basis financial statements.
Therefore, if your company needs to apply for a loan or line of credit, a bank will likely require accrual-basis financial statements. Further, if the company would like to sell all or a portion of the business, a sophisticated buyer will convert the cash-basis activity to accrual-basis financial statements when evaluating the transaction. This conversion can lead to further discounting of your financial results than if you had initially used accrual-basis accounting. Also, the process and results of the conversion could delay or end the potential transaction. It makes sense to initiate accrual-basis accounting early, understand your statements and have some sense of comfort knowing that the financial statements are accurate and have already been through the conversion process.
While the conversion to accrual accounting may be time consuming upfront, the benefits extend beyond the valuation impacts described above. The improved accuracy of data facilitates the strategic decision in real-time, simplifies the budget and forecasting processes, and enables benchmarking financial and operational metrics against similar entities.
If you compensate your employees based on financial results, cash-basis accounting can be misaligned and inconsistent with actual performance. Accrual-basis accounting with proper revenue recognition is recommended for compensation plans that rely on profitability metrics.
One last thing to consider: if your company ever requires a review or audit of its financial statements, you will need to transition to accrual-basis accounting. Since most audited financial statements report two years of data, you will need to restate two years of your books to accrual-basis.
Implementing best practices today will assist in the management of the company and mitigate future risks. Additionally, once the initial conversion is complete, the time and cost to maintain accrual based records is not often significantly higher than cash-basis accounting. The conversion to accrual-basis accounting is an investment in your future that will simplify future initiatives and make your financial results understandable to external stakeholders.