In order to achieve accounting compliance, efficient operations, and intelligible finances, a company must first develop a plan, determining the required or most suitable accounting method and using basic accounting tools for calculating cash flow.
The Cash Accounting Method involves recording revenue and expenses at the time of the transaction, when payment is actually received or sent. For example, using the cash method, a bookkeeper should record income when payment is received – not when the invoice is sent. Likewise, an expense should be recorded when paid – not when the bill is received. Cash basis accounting represents the actual flow of cash to and from a company.
The cash method is appropriate for cash based businesses or companies providing services like creative or mobile app developers. The cash method, however, limits the diversity of transactions a business can exploit; the cash method does not facilitate extending credit to customers. While the cash method provides a real-time, running balance of what is in a company’s bank account, it can convey a distorted picture of the company’s actual income and expenses. The cash method does not take into account payments which have not been received. It also does not account for unpaid debts. As a result, the cash method can hide a large, unpaid debt, making revenue appear greater than it actually is.
In contrast to cash accounting, the Accrual Accounting Method requires income to be recorded at the time it is earned (accounts receivable) and deductions to be made at the time expenses are incurred (accounts payable). For example, using accrual accounting a bookkeeper would need to record earned income when an invoice is sent and expenses when bills are received, whether or not the actual cash transaction has occurred. Using the accrual method, a purchase made on a credit account would be recorded as income before the account has been paid. Accrual basis accounting quantifies a more universal picture of a company’s financial status than cash basis accounting can provide.
Accrual accounting requires the use of a double-entry accounting system. Double-entry accounting uses one column to record income and expenses and another to track the entries as they are received or paid. Although accrual accounting can make it difficult to see actual cash on hand, the method gives a company the most accurate idea of the state of its finances. Due to the system’s capability to multi-task (track invoices and a company’s health), the accrual method is the most commonly adopted both by companies required to use the method and those which are not.
By using accounts payable and accounts receivable, a hybrid accounting method can be utilized for tracking cash on hand and remaining tax compliant with the accrual method. If a business has an inventory of merchandise, it can use the accrual method for records pertaining to inventory and the cash method to track income and expenses. This allows a company to use its accounts payable and receivable for sales transactions as they occur, making financial forecasting and trends analysis more accurate and giving small businesses a better cash on hand value to use in daily operations.
Determining Which Accounting Method Your Company Must Follow
In Revenue Procedure 2001-10 and Revenue Procedure 2000-22, the Internal Revenue Service (IRS) outlines business accounting method requirements for tax purposes. These documents give guidance to small businesses in selecting or switching accounting methods. The IRS Revenue Procedure 2000-22 allows any entity (partnership, sole proprietorship, S Corporation, or C Corporation) to use the cash accounting method for tax purposes as long as it meets the sales test. A company passes the sales test if its average revenue for the prior three years totaled less than one million. If a company does not fall into any of the categories which require the accrual method, the company may elect to use the method which best suits its accounting needs and capabilities.
Depending on the type of business entity, the amount of a company’s average annual gross revenue over the prior three years, and the nature of goods sold, the IRS may require that a business adopt the accrual accounting method.
The IRS requires the following types of entities to use the accrual method:
- All C Corporations, excluding farms, which fail the $5 million test (companies whose average annual gross revenue for the preceding three years totaled over five million) must use the accrual method. This requirement includes tax shelters and general partnerships partnered with C Corporations that fail the $5 million test.
- Due to the material income-producing factor rule, companies which, over the past three years, gross an average of over one million dollars selling merchandise that can be separated from a service are required to use the accrual method.
- In the historic court case, Osteopathic Medical Oncology and Hematology, the court held that the material income-producing factor rule does not apply when materials cannot be separated from a service or when the sale or function of the materials was secondary to providing a service. This particular case dealt with the question of whether chemotherapy treatments, for tax purposes, should be considered a product or a service. This rule has generally held for other businesses whose products cannot be delivered apart from the service (medical specialists, contractors, or architects). When the cost of the product is 8% or less than the total amount of the receipts, the business has been considered a service business and has not been required to use the accrual method.
Whether a company is required by the IRS to use the accrual method or has the freedom to select which accounting method it uses, the advantages, disadvantages, and differences between the accrual and the cash methods of accounting should be understood.
At the end of a company’s fiscal year, the type of accounting system in use must be considered when planning the timing of transactions. The accrual method offers the most flexibility with tax liabilities because transactions are recorded at the time of billing and not when cash is received. This affords companies more control over when income is recorded. An invoice can be sent during the current year to have income counted in that year or billing can be delayed until the new fiscal year. Also, if a company uses accrual accounting, expenses can be taken on in the current year and actually paid for in the new fiscal year. If a company uses cash accounting, then it must anticipate total revenue and expenses, paying bills in the year when the company can expect the least amount of income.
ACCOUNTING & BOOKKEEPING BASICS
In order to maintain accurate and compliant accounting systems, companies need to utilize some basic bookkeeping tools. While accounting is the process of analyzing and measuring a company’s performance, bookkeeping is the practice of maintaining records necessary to facilitating the accounting process. Not only does accurate record keeping help measure revenue, it also deters any dishonest behavior within an entity such as fraud or embezzlement. An accurate and organized bookkeeping system, or set of rules for recording financial information, will ensure accurate accountancy. Reliable accounting begins with the completion and analysis of three basic accounting forms: the profit and loss statement, the balance sheet, and the cash flow statement.
Profit and Loss Statement (P&L)
The P&L, also known as an income statement or an income and expense statement, provides a summary of incurred expenses, costs, and earned revenues over a fiscal quarter or year. The P&L illuminates a company’s ability to trim costs, increase revenue, and generate profit. The P&L follows a basic format, beginning with an entry amount for revenue and subtracting operating expenses from revenue.
- Revenues: On the P&L, revenue is the income which an entity receives through sales or donations (in the case of a non-profit). Revenue usually occupies the top line on an income statement. This top line is used for INC 500 list qualifications.
- Expenses: Expenses are the outflow of cash and valuable assets. All of the expenses involved in running a business turn up on the income statement. Everything including the cost of goods sold (cost of acquiring merchandise or manufacturing), operational expense over a specific period of time, and depreciation of assets.
The bottom line of the statement equals the company’s net income, hence the figurative term “the bottom line.” Net income differs from net profit in that it includes financial elements other than profit from goods sold (net profit = cost of goods sold – sales). Net profit considers depreciation, amortizations, cost of capital, tax expense, and operating and capital expenses. The P&L provides a format to account for all the components which go into figuring a company’s net income.
The Balance Sheet
A balance sheet, sometimes called a statement of financial position, displays the value of a company’s assets, liabilities, and shareholder s’ equity at a particular time. These three values give investors and company leaders a picture of the entity’s net worth by showing how much the company owns, owes, and has in shareholder investments.
All balance sheets follow a similar format: Assets = Liabilities + Shareholders’ Equity. Each item in the equation, titles a column of corresponding accounts, which provide a value for that column. For example, accounts like inventory, cash, property, current, and non-current assets would be found under the assets column and accounts like long-term debt, current liabilities, and accounts payable would be listed under liabilities.
- Accounts Payable (AP): Listed under current liabilities on the balance sheet, accounts payable represent a company’s obligation to pay off any short term debt to creditors or suppliers. These accounts must be paid within a certain period of time to avoid default.
- Accounts Receivable (AR): Listed under the current assets column of the balance sheet, accounts receivable include any customer or client (individual or corporate) obligations to the company. Most often accounts receivable exist when a company allows customers to operate on credit accounts, paying on a periodic invoice.
The accounts listed on balances sheets vary depending on an entity’s unique financial situation, industry, and type of business. Though the types of accounts listed under assets and liabilities will vary, the basic structure of the form is universal and applies to all businesses.
When studied properly, the balance sheet provides information on the overall financial health of an entity. Ratios like the working capital ratio (current assets/current liabilities) and the debt to equity ratio (total liabilities/shareholders’ equity) reveal the financial status of a company.
Cash Flow Statement
A cash flow statement is a comprehensive financial document, typically completed quarterly, which monitors and tracks the total flow of cash in to a company from operations revenue and investments and all cash flowing out of a company for operating expenses and investments. The cash flow statement proves extremely valuable to companies operating on an accrual accounting system, which often clouds the true value of a company’s cash on hand.
While the P&L, balance sheet, and cash flow statement can be individually worthwhile, they are most helpful when looked at together; each statement provides information on different aspects of an entity’s financial health. By considering all of these values together, one can gain an exceptionally accurate representation of a company’s well being.
Most of the expense and revenue values needed to complete these essential forms can be drawn from the daily transaction records kept by a bookkeeper in a company’s ledgers.
An accrual accounting system will require a double-entry ledger, but most bookkeeping systems utilize this double-entry method. A bookkeeper will record all of a company’s monetary transactions in a double-entry ledger with debits in one column and credits in a separate column. When the books are balanced, the credits column should equal the debits column. This allows the bookkeeper to track invoices and payments. Typically, two ledgers are kept at the same time, one for recording accounts receivable (sales) and the other for recording accounts payable (money spent).
Though keeping up with double-entry bookkeeping system and updated financial statements can appear to be quite a bit of work and can take some getting used to, most available accounting software will handle the double-entry system and pre-fill financial statements, without your bookkeeper having to do any extra work.