A question we often get from clients who are used to keeping their books on a cash basis is why do the accruals matter?
If you aren’t trying to grow your business, have plenty of time for family and friends in your typical day, and like things how they are, then maybe the accruals don’t matter.
But if you are one of the thousands of entrepreneurs world-wide who never have enough hours in the day, aspire to grow the business beyond its existing plateau, or want to sell their business for a premium at some point, then correct books are critical. And accruals necessary part of that.
Here are some examples:
Insurance Premiums
Many businesses pay their insurance premium once per year. If that insurance premium is simply entered into your books in the month it is paid then that month will have a horrible profit margin. And the other months won’t have any insurance expense at all in them even though the policy was in effect during those months. To complicate the matter even further, many insurance companies will finance your insurance premium for you, but often over only 10 months, not the 12 months that the policy covers. In this instance a cash basis accounting system will put 12 months of insurance into 10 months and two months of each year will appear better than they really were. Proper accruals fix that and distribute the insurance evenly across the year, giving you a better picture of how you actually did each month.
Accounts Receivable Collections
Under a cash basis of accounting revenue is recognized as cash is received. Suppose you have a really good month in March, but your customers don’t pay until April. Then in April you have a mediocre month and your April customers all pay pretty quickly. When you add the payments from your March customers which you receive in April and your payments from your April customers which you also received in April, April will look like a better revenue month than March even though the opposite is true. In an accrual-based accounting system the revenue will be recognized when it is earned. When the customer actually pays becomes part of a separate cash tracking system. That way you’ll be able to see which months were profitable and which weren’t AND also be able to track which customers need to pay you.
Taxes???
“Yes – but what about taxes?” Many will push back with, “My bookkeeper says I need to keep my books on a cash basis in order to save on taxes.” Our response to that will be the subject of our next post…