11 Jun Better Financial Information, Better Decisions
Modifying your accounting processes can improve business information, help you make better decisions and uncover insights to better manage your business. Here’s how.
Many small organizations record their financial information on a ‘cash basis’ as opposed to an ‘accrual basis’. Other organizations record a ‘modified cash basis’ – a blend of cash basis with some accrual accounting. As accountants, a significant amount of our time, and therefore cost, is spent converting cash basis information to an accrual basis and then preparing financial statements from this revised information.
At Clearline CPA, we prefer accrual basis accounting for many reasons. Accrual accounting is more meaningful as it provides better information for making business decisions. It is also the required basis for filing corporate tax returns and preparing financial statements in accordance with generally accepted accounting principles.
Cash Basis Accounting
Recording transactions on a cash basis means that the business records transactions when money is exchanged. For example, a company might record sales when the customer pays for the good or service instead of when it is provided. Similarly, it might record purchases when they are paid instead of when the goods or services are obtained or used.
Cash basis accounting is fine for record keeping, but it does not provide information that is as useful for making business decisions. This is because the profitability of the business is based on when cash is received or paid. Often, this can lag significantly, or payments can be made up front. These timing differences can significantly distort the calculation of profitability. In other words, with cash basis accounting, it is possible for a business that is making losses to look profitable at certain times, and inversely for a profitable business to look like it is losing money at certain times.
Accrual Basis Accounting
Accrual accounting records revenue when it is earned. That means that the services have been provided and/or the goods have been delivered. Accrual accounting then matches the expenses that are associated with providing the services and goods and records them in the same period. This ensures that the financial reporting is reliably showing what the company’s profits are.
Let’s look at some examples to see how businesses work with information based on their cash or modified cash basis accounting.
Example A – Inventory and cost of goods sold
A manufacturing company buys goods throughout the year that it uses to produce its products for sale. Depending on the time of year and the stage of production, the amount of goods on hand (i.e. inventory) will go up and down. The company posts all of its purchases to cost of goods sold when it receives the invoice which can be a few weeks after the products are received. Management performs an inventory count at year-end and an adjusting entry is made to remove some of the costs from cost of goods sold to inventory.
This is a common scenario and it is very problematic if management wants to use its financial data to understand its costs and profitability. We will examine two significant issues one by one:
Issues at year-end: Because the goods are recorded when the invoice is received, and there can be a significant lag from when they are received, the cost of goods sold will tend to be understated. This is because goods included in the inventory count have been moved to the balance sheet from cost of goods sold but the actual cost may not have been recorded, as it will be recorded when the invoice is received. This means the business will look more profitable than it actually is. It could lead management to make decisions it may otherwise not make such as paying bonuses, expanding its production, etc. Also, because income is overstated, the business will pay more tax than it ought to be paying which means more money in the hands of the government and less in the business to pay bills, salaries, and compensate the shareholders. If this business doesn’t track when goods are received, and this information is not included in the supplier invoice, then we as external accountants won’t have the information to be able to make the necessary adjustment. This undetected error could go on year after year.
Issues during the year: In this case, the business only conducts an inventory count once a year and only makes the accrual adjustment for inventory once a year. This could lead to severe misinformation for management when trying to evaluate the information and make business decisions. Depending on the time of year, if inventory levels are significantly higher or lower than at year end, the cost of goods sold may be overstated or understated. This means decisions will be made without actually knowing the actual profits the business is making, and management could be making too many or too few income tax instalments.
Example B – Accounts receivable and bad debts
A company that provides credit to its customers (i.e. it lets them pay within 60 days of the invoice) records its sales and accounts receivable when it delivers the product to the customer and then eliminates the accounts receivable when it receives payment from the customer. Only when bad debts are specifically identified are they directly written off of the books.
The above is extremely common. It is an example of a modified cash basis. While it is close to accrual accounting, it still comes with some problems. Sales are being recorded when the products are delivered which is good. he problem here is the bad debt write offs. Accrual accounting requires companies to estimate their bad debt expense and record an allowance for doubtful accounts at the time sales are made.
Why do this? In the example above, the business realized the loss on bad debts very late in the process and so the company will appear to be more profitable than it actually is. Again, this leads to poor information for decision making. Very small businesses tend to collect revenue better when the operations are small. In most cases, the business owner deals directly with the client and has time to follow up on collections. However, as the business grows, this becomes more difficult. If the company’s bookkeeping or sales staff do not actively follow up on collects, they become stale and bad debts become an increasing problem. We see this trend in almost all growing businesses. Over time it can cause a huge disconnect between what the owner thinks profitability is and what it is in reality.
In addition to the poor information on profitability, the company is required to pay income tax on the sale in the year it is delivered not when the cash is received. Let’s assume that an un-collectable account sits on the books for two years before it is finally written off. Well the company has paid tax on cash it never received and only gets the tax back when it is finally written off. Let’s further assume that the total bad debts that have accumulated are $100,000 and that business pays income tax at an effective rate of 20%. In this case, the business may have overpaid its corporate taxes by as much as $20,000!
Not getting paid for your products and services is bad enough, paying tax on these amounts is downright sinister. But this can be resolved with proper accrual accounting. The best thing about an allowance for doubtful accounts is that you don’t directly write off the receivable on the books, meaning you still have a record of it (which you don’t when you directly write if off) and can still attempt to collect it.
So what should you do?
We hope the way forward is becoming clear. Cash basis information is not suitable for calculating income tax and does not provide business owners and managers with the information they need to function at their best. Even modified cash basis information can have vast differences with proper accrual accounting and lead to making sub optimal decisions. Moving your books to be more in line with accrual accounting is the way to resolve these issues.
At Clearline, we can help you identify the best ways to arrive at better financial information. Being equipped to make better decisions also means a faster turnaround on your year-end financial statements and reduced costs to prepare your corporate tax return.