One of the most accurate truisms in small business is that the company’s accounting process ranges from terrible to extremely limiting. Lack of understanding and non-existent accounting personnel are the reasons for this shortfall.
However, I get it. In the early years of a new business, the top priority is finding and getting customers and hoping there is enough cash in the till to meet next week’s payroll.
Accordingly, the owner isn’t focused on profits and profit improvement. It’s about staying alive and monitoring the bank balance. However, if this mindset persists, the owner will truly never understand how they are performing financially, and their reporting could lead to an unbankable financing situation–that is, the banker doesn’t trust the numbers, which can destroy the owner’s credibility.
To resolve this accounting problem, a little bit of education is needed. After that, any business owner needs to invest in an accounting manager as quickly as possible once the business pushes past $2 to $3 million in revenues. This is not a lengthy discussion, as the focus is on revenues and expenditures.
Accrual Accounting vs. the Cash Basis
I will bet my net worth that 99% of all businesses that launch a business use the cash-based method of accounting. This is the same method owners use for personal financial management, so they apply it in the business.
While I do not want to dumb down this part of the discussion, it’s critical to understand this concept. The best way to understand accrual accounting and reporting is through two simple questions:
- When is revenue earned?
- When are expenses incurred?
In the first question, we’re addressing revenue recognition. In the second question, we’re addressing the timing of an expense. Just because your office manager booked rent in the same month on the 1st and the 30th, that doesn’t mean you incurred two month’s worth of rental charges. That $250,000 payment for inventory not sold for another 45 is not expensed when the bill is received or paid.
Accrual accounting and reporting is about timing and recognition. Accrual accounting dictates when revenue and expenses are recorded.
Now that we’ve scratched the surface of accrual accounting, you should have a general idea about revenue.
Since we’re discussing accrual accounting, a word pairing comes to mind with revenue–recognition. Revenue recognition is a concept that the business owner and her accounting manager need to understand fully. Deciding on revenue recognition can be nuanced in certain situations. For instance:
- General contractors can either recognize revenue on the complete-contract method or the percentage of completion method. The latter is the most prominent when annual billings exceed $10 million, and competent accounting staff is employed.
- Subscriptions collected in advance for any industry require accounting treatment based on when the revenue is earned, not when it’s collected. That’s even the case for any SaaS receiving full payment for a year’s service for its online product.
- Even manufacturing entities bear special consideration because some purchase orders will state FOB Shipping Point or FOB Our Dock. Those PO terms dictate when the revenue is earned (in one case, it is when the customer receives the shipment, and in the second case, when the product is sitting on the owner’s dock awaiting to be shipped).
If your company is audited or subject to a review, you will not have the final say on revenue recognition. Instead, that will be left to Generally Accepted Accounting Principles (GAAP). GAAP has the final word, but I encourage any owner to follow GAAP’s revenue recognition guidance where audits are not required.
I have worked with many accounting managers over the years, and I have seen many tripping up on how to classify certain expenditures, such as the following:
- Costs that are pulled or driven by revenue
- Costs that are used to support the top line or business
- Paying vendors for past services
- Bank debt payments
- Reimbursements to sister companies
- Owner distributions
The above list is not complete, but it’s close. Every accounting manager should know the accounting treatment for each expenditure type above without thinking about it. It’s a form of expense muscle memory.
My favorite way of knowing when or how to recognize expenses is all about timing. If the expense is directly tied to revenue, then the expense occurs when revenue is recognized. If not, the expense is recorded when the good or service is consumed. Again, timing is the key here. The accounting gods call this the matching principle. Costs either match revenue or time.
Ignore These Accounting Concepts At Your Peril
“Mark, I just want to sell my product.” These accounting concepts do not add one penny to my bottom line or net worth. It’s a waste of time.”
That owner is right up to a point. What if you are trying to sell the business? What if you need a bank loan? What if you are subject to third-party reporting requirements?
More importantly, how do you know how you are doing if you only use cash inflows and outflows to determine financial performance? It’s generally impossible. The owner needs a system and structure to understand how the business is performing while using cash flow tools to project cash needs weekly through the next month or two.
The good news is that accrual accounting and a better understanding of revenues and expenses can be grasped quickly. The hard part is shifting the mind away from what is seemingly easier to grasp and use.