CFO Consulting Topics: Accrual Basis Accounting for Small Business

CFO Consulting and Accrual Basis Accounting

Ready for a round of CFO Consulting Topics? This month, we’re tackling a key question for small business owners everywhere:

What’s the difference between Cash Basis Accounting and Accrual Basis Accounting?

Both the cash basis and accrual basis of accounting are acceptable approaches to bookkeeping, and in many instances, cash basis is the preferred way to record transactions for tax purposes, especially for small business owners.

But…

The accrual method is the proper Generally Accepted Accounting Principles or “GAAP” way to record your books and is required for publicly held organizations.

If you are a small business owner currently employing the Cash Basis Accounting method, below are a few key CFO consulting insights on how Accrual Basis Accounting can be applied in small business situations.

About Cash Basis Accounting

Cash basis accounting is the methodology of tracking your business receipts and expenses as you pay for them. If you receive money for your goods or services, you record revenue when the money is received regardless of when the services were delivered to your customers.

Likewise, you record expenses when you pay them, regardless of when you incurred those expenses.

How to Approach Accrual Basis Accounting

With accrual basis accounting, you record revenue when the service is delivered. You may have customers that you perform services for on a subscription basis (monthly retainer). These customers are typically billed monthly and that is when the revenue is booked, regardless if your customer has paid for the service.

Accrual accounting also records expenses in the period incurred, regardless of when they have been paid. If a company has received a service from a vendor, the expense associated with that service is recorded as accounts payable or accrued liabilities in the period the obligation was incurred.

That’s not all.

Taking the accrual accounting concept even further, if something is paid for in full, like an annual insurance policy for liability insurance, the proper way to account for this is to record the entire payment in a prepaid asset account when paid and expense the monthly portion and reduce the asset each month of the year.

Other items that should be recorded as an asset — or potentially recorded as a deferred liability account — and amortized monthly would be customers who have prepaid for a service or who have been required to make a deposit.

For example,

If a customer pays for a three-month service in full when the contract is signed, the proper way to record this is to establish a deferred revenue liability account or customer deposit asset account for the entire amount and reduce the balance each month while recording the appropriate revenue.

Here is how it would be recorded (customer prepays for 3 months of service for a total of $6,000 or $2,000 per month):

  • At contract signing and receipt of 3 months of service: Debit cash $6,000 and Credit $6,000 deferred revenue liability
  • When the first month of service has been provided to the customer: Debit deferred revenue liability $2,000 and credit customer revenue $2,000

When Should Small Businesses Use Accrual Basis Accounting?

There are many more complex transactions that require analysis and estimates (bad debt reserves, warranty liability reserves and tax estimates to name a few).

However…

If you record obligations as expenses and liabilities when incurred, record revenue and accounts receivables when the service has been delivered and the value has been determined, you will be well on your way to properly recording your books on the accrual method of accounting.

If you have a business that is growing, and you are thinking about bringing on investors or potentially thinking about selling your business then the accrual method of accounting is the proper method to use. ChoiceFinance’s CFO Consulting services can prepare your business for these next steps.

Why the Balance Sheet Should Matter to Small Business

Small Business Consultant with Balance Sheet and Paper Airplane

I started my career in accounting and finance in 1986 working for Peat Marwick Mitchell, a Big 8 Accounting firm, as an auditor. In that role, we were taught to examine the balance sheet accounts in detail and perform spot checks of the Income Statement accounts.

Why would you do this?

The answer is simple. Accounting is a process of recording your business transactions by creating debits and credits in your “books.” Every journal entry must balance or have the same value of debits and credits. If you prove out that the balance sheet accounts are correct, the Income Statement must be correct in total with, at most, a reclassification that might need to be made between revenue and expense accounts.

How to Use the Balance Sheet

As a small business financial consultant working with owners over the years, I found that a majority of them don’t pay any attention to their balance sheet and really only care about revenue and profits.

Putting myself in their shoes, I can understand why.

You are in business to make a profit, right? And the profit comes from generating more revenue than expenses. So, the logic makes sense. But I can tell you that I find countless issues when looking at the balance sheet.

Here’s how I do it.

If I receive an owners balance sheet for 2 years, I like to go to the liability section of the balance sheet to look for changes in the accrued liability accounts — accrued payroll, payroll withholdings, payroll tax liabilities etc. In many instances, I will see the same balance being carried from period to period or a balance that continues to grow and never become smaller. When I see that, I know there is an issue.

Depending upon the payroll cycle, these accounts should increase after processing a payroll then when the liability is funded, preferably within a few days, the liability is reduced by the payment to the various vendor — retirement account, tax agency etc. If these accounts are not showing the proper pattern of debits and credits, you can bet there is a problem that needs further investigation.

Accounts Payable and Accounts Receivable

I also like to look at the accounts receivable detail and the accounts payable detail. As a small business financial consultant, I like to ask myself some questions:

  • Are we collecting our money in a reasonable fashion?
  • Are we paying our vendors on time or are we paying them too soon?

Looking at this detail will give you a great idea of the cash flow cycle of the business.

Are we using a business credit card? If no, why not? All business owners should take advantage of reward credit cards that provide up to 2% cash back or miles/points for your purchases. It doesn’t take too long to accumulate $100,000 in charges which can provide for a free roundtrip flight or $2,000 in cashback rewards!

I once worked with a not so small business owner who had $50,000 in monthly expenses that he could have been putting on a rewards credit card and receiving $1,000 in monthly cash rewards!

Reviewing the Income Statement

I don’t ignore the Income Statement by any means, especially as a small business financial consultant. I will perform an analysis of gross margin (in total and by product line) and will review the various accounts to determine if they appear reasonable as a proportion of revenue for the company.

We may uncover some inefficiencies during this process, but it is less likely to uncover errors in the Income Statement (although it does happen). Most people know where to record revenue and understand where to record wages or rent paid to a landlord. But, more often than not, knowing exactly how to record payroll withholdings or how to record customer deposits received in advance can be difficult for a small business owner.

Do you think you may have errors in your financial statements? Want to make sure that your financials are in good shape before pursuing a Line of Credit or a business loan to expand your business?

A small business financial consultant can help!

Contact ChoiceFinance and we can do a review of your financials and let you know what we find.

How to Use ROI in Small Business

You have seen this acronym used many times, but let’s make sure you know what it means and how to calculate it.

What is ROI?

ROI means Return (what you have received) On your Investment (the amount you have spent to generate your return).

On the surface, this is a simple concept and can be calculated very easily. Let’s look at a couple of examples to reinforce this idea:

Someone invests $1,000 in the stock market and at the end of one year this investment is worth $1,225. The return (what we received) is $225 and the investment (what was spent to generate the return) was $1,000. Therefore the R.O.I. on this investment was 22.5% ($225/$1,000).

How to Calculate ROI

Now let’s take this concept and use it in calculating the R.O.I. of ABC Company’s marketing investment in customer acquisition.

In 2018, ABC Company invested $36,000 ($3,000 a month with a digital marketing company to manage its paid advertising campaign. This $36,000 included money spent on Ad Words with various platforms, Google, Facebook and LinkedIn).

Let’s look at the return this investment yielded.

The marketing campaign generated a total of 220 leads during 2018 from which ABC Company was able to turn 11 of those leads into paying customers. Here is where the analysis can get more complicated. More data is needed in order to calculate the ROI ABC Company generated in 2018.

We know the investment was $36,000. The 11 new customers spent $33,335 with the Company during 2018 (ABC sells annual subscriptions billed monthly). The return on this investment in 2018 was negative ($33,335 of revenue generated on $36,000 of investment resulting in a negative return of $2,665 or -7.4%).

On the surface, one might look at this as a bad investment. However, we need to dive deeper and understand the lifetime value of these customers.

We know our total investment is $36,000 and taking it a step further we uncover that our average customer stays active for 26 months and bills at an average of $461.81 per month. Our marketing efforts in 2018 generated lifetime revenue of $132,078 for these 11 customers (11 x $461.81 per month average x 26 months as a customer). Now we have the data we need to understand the real R.O.I. generated from our 2018 marketing activities.

The actual R.O.I. generated was 267% ($132,078 of revenue created on $36,000 of marketing spend generated a return of $96,077 or 267%).

Not a bad return! For every dollar invested in this marketing campaign, we received $2.67 of revenue.

Takeaways

This was a simple example and didn’t take into consideration the cost of any ABC Company staff working on the campaign or any sales related costs (if any) of obtaining these new customers. There are many factors that go into calculating ROI This calculation can be overwhelming for some.

In order to know how your investments are performing, start tracking your financial data. Tracking the data is the first step. Once you have several months of data you can start to analyze it and evaluate the success of your efforts or better put, know the Return on Your Investment!

If you need help, reach out to ChoiceFinance and schedule a meeting to review your information.