A basic question for any business is whether you keep your books on a cash or accrual basis. In QuickBooks, it’s a question you usually answer when setting up your company in the program for the first time. You can change your accounting basis later on, but cash is simpler and a common first choice of small businesses.
Cash Basis
QuickBooks generally reports cash on hand when you use it on a cash basis. It records income when you receive payments and expenses when you pay a bill. Outstanding invoices do not count toward your profit, nor can you deduct expenses when you incur them but only when you write the check.
Cash Reports
If you set up your company on a cash basis, QuickBooks’ summary reports, which cover groups of transactions, including profit and lost summaries for a set period of time, are produced on a cash basis. As a result, a good month in which you took on major projects for clients could show up as a loss in a QuickBooks monthly profit/loss report. It’s not until the next month when your clients pay the invoices that your books show the profit you earned from those projects. By default, however, QuickBooks produces individual transaction reports on an accrual basis. Individual transactions can be listed by date, customer or vendor. A report on invoices for a given month, for instance, shows all invoices you created and sent, regardless of how many are unpaid.
Accrual Basis
When you use an accrual basis for your bookkeeping, you record income when you provide a service or ship a product. You count expenses when you obtain a purchase. The original transaction and the time money changes hands are separate events for accounting purposes.
Accrual Reports
All general QuickBook reports show income and expenses accrued instead of paid when you set up your company on an accrual basis. You record income when you create an invoice for a completed project or sale of goods, and record expenses when you receive a bill. Your profit/loss report coincides directly with work completed and expenses incurred, but it’s only bank account registers in QuickBooks that show cash on hand. Reports on Accounts Receivable show money owed by customers and Accounts Payable on money you owe vendors.
Which to Use
Many businesses see the accrual basis as producing a better picture of a company’s profitability. An annual profit/loss report broken down by months accurately shows the highs and lows of your business operations. Businesses more concerned about cash flow, however, have an advantage in using a cash basis. It’s also the basis people are most familiar with from their handling of personal checking accounts. While it can be a matter of choice which basis to use, if your business keeps an inventory for merchandise you produce, purchase or sell, the Internal Revenue Service generally requires you to use an accrual basis for accounting.
Cash vs. Accrual Based Accounting…. What does it mean to the Small Business Owner?
In my opinion, one of QuickBooks’ best features is its ability to run financial reports, like a Profit and Loss, on both a Cash and Accrual Basis. But I am often asked by my clients “What does that mean? What is Cash vs. Accrual?”. I’ll try to answer that question here on a level that applies to the Small Business Owner evaluating his or her Profit and Loss Report and Balance Sheet. I’ll try to leave out the accountant-speak and technicalities.
Your Profit and Loss Report is a snapshot of your business’ income and expenses for a specified period of time. Your Balance Sheet report is basically a report of what you own, what you owe, and your business’ Equity (the difference between what you own and what you owe) as of a certain date.
Let’s talk about Accrual basis first.
When you are looking at your Profit and Loss report on an Accrual basis,
- Your income will include everything you billed customers for during that time period, whether or not you have been paid by those customers.
- Your expenses will include bills from vendors that you have entered into QuickBooks for a that time period, whether you have paid the bills or not.
On an Accrual Basis, the Balance Sheet report will include:
- What is owed to you (customer invoices, called Accounts Receivable)
- And what you owe (outstanding bills to your vendors, called Accounts Payable).
In order to achieve good Accrual-based reports in QuickBooks, you need to use the Customer Invoicing and Enter/Pay Bills features. It’s also a good idea to pay attention to the dates you bill your customers and bills you enter from your vendors, to be sure they are posted in the period they were incurred.
Most small businesses file their taxes on a Cash Basis, so why would you want to evaluate your finances on an Accrual basis? I ALWAYS recommend evaluating your business’ financial performance on an accrual basis at least monthly, because what you have collected from your Customers and what bills you have paid aren’t necessarily indicitive of your business’ earnings performance.
In fact, many businesses will show a profit on their Cash Basis Profit and Loss Report right until the day they go out of business! Because if you don’t show an expense when it’s incurred, but when it is paid (like on a Cash Basis, which we will talk more about in a minute), your expenses are understated.
Let’s look at a professional services business like mine, for instance. First of all, we bill many of our clients on an hourly basis, so I make sure to bill out as much time as possible on the last day of the month. That way, when I run our Profit and Loss Statement, I can see what we earned that month, not necessarily what we collected, but what we earned.
Like any business should, we know what we need to earn every month to break even. I may have cash in the bank because I haven’t paid all the bills yet, or because I collected on some old invoices from customers, but that doesn’t necessarily mean that our business has performed as it should.
Income is the largest consideration in our business, but it holds true with expenses as well. Expenses should be entered into QuickBooks as Bills for the date they are incurred. That way your Accrual-based Net Income (Income less Expenses) for the period you are evaluating is a true indicator of your performance for that time period. Did you spend more than you earned for that period? If so, it may take a month or two to catch up to you, and you want to be prepared. Are you showing consistent earnings yet your cash flow is suffering? You may have an issue with collecting on outstanding invoices from customers.
So what good are Cash basis reports? For one thing, many businesses file their taxes on a Cash basis, so you want to keep on top of what your income is going to look like for tax purposes. Cash basis reports are also more closely tied to your business’ cash flow. When you look at a Profit and Loss Report on a Cash basis, you are only going to see Income from customers that you have actually received in your hot little hands. You will only see expenses for things that you have actually paid. If your business operates on a cash basis – meaning you pay for your business expenses as you incurr them and collect money from your customers on the spot, your Cash basis and Accrual basis reports will be the same.
In many cases, your financial statements may require additional adjustment. Contractors, for instance, should adjust their Profit and Loss statement to account for over and under billing. What I mean by that is this: A lot of contractors, particularly those who do fixed contract billing, may “draw” $100k on a job at the end of November, but may not have incurred many, if any expenses toward that revenue until the following month. If we left all of that income in November, our revenue vs. costs would be very skewed. This is one reason why contractors can show a huge profit for months during a big job, and then run out of money at the end of a job and not understand why!
If this sounds like something you would like to know more about, I can help! I offer one on one coaching on this subject specifically. You can set up a strategy session with me at: www.meetme.so/pennylane or learn more about my coaching and CFO programs at: www.jobcosting.com/coaching