Accrual-based accounting: Sales are recorded when
the sale occurs, no matter when you are paid. Expenses are incurred
when you receive goods or services, even though you may not pay the
bills for them until a later date.
Cash-based accounting: Sales are recorded when you receive
the money and expenses are incurred when you pay the bills.
Although financial numbers don't lie, they're subject to
different accounting methods that can lead to different
interpretations of a company's financial position.
There are two basic methods for keeping track of sales income and
the money paid out for expenses: cash accounting and accrual
accounting. Typically, businesses with revenue of more than a few
million dollars choose accrual accounting to handle the greater
financial complexity those companies face.
Choosing the right accounting method can make the difference
between an accurate reading of profit and loss and a conceptual
figure that leaves you clueless. Accounting can also make the
difference between knowing when you have money in the bank to cover
an expense and when you don't.
Knowing how much money you actually have on hand might be a good
clue as to whether you've budgeted enough to pay expenses between
the times when your customers pay their bills.
An information technology manager who doesn't know how to look at
the numbers from both accounting points of view risks not knowing
when his business is in trouble. Cash accounting will show that
there's really no money in the bank or if today's bright revenue
picture will be offset next month by heavy expenses. Accrual
accounting matches revenue and expenses within a given financial
period to avoid surprises.
Suppose you're running an e-commerce Web site. A customer orders
$100 worth of merchandise in January and pays immediately with a
credit card. However, in February the customer backs out of the sale
by canceling the credit-card transaction -- but keeps the
merchandise you shipped. You're now stuck with a debt that may take
months to resolve through collection agencies or the courts.
Under cash accounting, that $100 in income you recorded in
January is recorded as a negative $100 income in February, says
Lissa Redmond, president of accounting firm Total Tax Solutions Inc.
in Glendale, Calif. That's a simple matter, and it shows your
financial standing immediately. But under accrual accounting, you
record that $100 in income in January. When the transaction is
canceled, receivables -- cash you are owed -- increase by $100 in
February to compensate for the lack of payment.
About a year later, after the debt has proved impossible to
collect, you record the bad debt as a $100 expense and reduce your
receivables by $100. The accrual method takes into account when
transactions actually occur.
"You can say that cash-basis accounting shows you what you've
really got in sales and expenses," Redmond says. "While that's true,
cash-basis accounting will not show you the receivables of your
business, as accrual will. I strongly recommend that any business be
able to view both types of financial reports."
Most IT managers in charge of an e-commerce site don't have to
worry about choosing whether to keep the books on a cash or an
accrual basis because the company's accounting department makes
those choices, says Tony Tortorice, a partner in the global risk
management services practice at PricewaterhouseCoopers in Los
Angeles.
Although most larger businesses use accrual accounting, an IT
manager can still benefit from using software to look at the
financial information on a cash-accounting basis because it helps
him understand the sources and uses of the company's cash, Tortorice
says.
Having both views of the data is important because knowing where
the money is can make a big difference in how well your e-commerce
business runs. "If somebody sends me supplies, I want to delay
paying them as long as I can get away with it. Because I like having
free money, it means I don't have to borrow it at the bank,"
Tortorice says. "On the other hand, I'd like to get somebody who
owes me money to pay me sooner because they're using my money to run
their business."
There's one more reason to use both views of your financials.
Accrual accounting poses risks for the unwary, says Susan
Koski-Grafer, vice president of technical activities at the
Financial Executives Institute in Morristown, N.J.
"If a technology company sold a lot of products, it could have a
great accrued revenue stream [of receivables] that would make it
look successful," she says. "But if that company sold those products
to shaky, high-flying customer companies that couldn't pay, it could
go out of business quickly -- because you can't pay your bills with
receivables."
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