Should you run your business on a cash or accrual basis? What does this mean?
When I started my own law practice, I had to learn about accounting - the hard way. It wasn't until I took a course on how to use Quickbooks that I began to understand basic accounting terminology and what it meant. In the meantime, I got screwed by a "CPA" who was all-too-willing to exploit my ignorance. And that was my fault, not his. Jerks abound - it is incumbent on you to look out and avoid them.
Most of us live life on a cash basis, and it is the easiest way to live. You get paid, you have money. You spend it, or pay a bill, you have less money. It is the simplest way to live. And most of us close out our finances every December 31st, to calculate what we owe the IRS. But many companies do things differently. Their financial year may end in March, instead of December, so their finances are not being calculated during the busiest time of the year, or while everyone is on vacation.
And many companies use an accrual method of accounting, which can be quite confusing to us mere mortals.
Simply stated, accrual accounting logs as "income" anything you have invoiced for. You do a job, you send out an invoice, and you log that as income - even if you have not been paid yet. So you show a profit, even if your bank account is empty. Similarly, if you get a bill from a supplier for a service or product, you log this as an expense, as if it had already been paid, the moment you receive the invoice from your supplier. You may not pay them for 30, 60, or 90 days - or more - but the expense is effectively logged as "paid" in accrual accounting methods.
Of course, this accrual method can lead to trouble. If a client doesn't pay an invoice, or demands a discount, you have to go into your books and mark-down that invoice, which affects your profit picture next quarter. So one quarter, you show a wild profit, but then the customer who promised to pay you goes bankrupt, and the next quarter, you have to adjust your accounting to reflect this. Suddenly you go from wild profit to wild loss, although nothing has really changed much, in terms of your bank account.
I have never been a fan of accrual accounting as it seems to me to invite a lot of shenanigans. Enron famously used a version of this, called "mark to market" which would log future contract profits as received based on current market values. On paper, it might look like you are making an awful lot of money, even if you knew that the deals would go sour down the road or that the evaluations were somewhat specious.
It would be like if I sold you my car for $1M, and you agreed to pay that much for it. Of course, the car isn't worth anywhere near that. But I could argue - with a straight face - that I "made" a million dollars in that sale, even if you have yet to pay me for it. Of course, later on, I have to adjust my accounting when you sober up and refuse to pay. But in the meantime, I showed one quarter of incredible profits, and the stock of BobCo shot through the roof. And all of this is perfectly legal, of course - well, at least sort of.
Sort of makes you wonder, don't it? I mean, you hear about these "dot com" companies doing an IPO and they've been losing money for 14 quarters straight. Then, a few months before the IPO road show, they show a profit. Funny coincidence, I guess. Or some of these other companies that have already gone public, that show profits one quarter, and losses the next. Maybe overall profit, over time, is the key, not this short-term thinking that can be skewed by accounting practices.
For us little people, accrual accounting is just too complicated to deal with and provides little in the way of real advantages in running a business. For the small businessman, how much cash is on hand is more important to know than how much cash you could have if everything goes as planned.
