A former client has had to make a change in the accounting manager position at their company, and they hired a new manager before we began working together. We learned that the new accounting manager asked: “Why are you keeping your books on the accrual basis, when you file tax returns on the cash basis?” I was asked for my opinion.
Without commenting on the questionable credentials of the new hire, let me acknowledge that many small businesses face this same question, and far too often opt for cash basis accounting because it’s seen as simpler to understand and it makes their CPA’s life easier when income tax filing time comes around. So, in the interest of any of our readers for whom that’s a valid question, let me provide some insight.
Cash basis accounting is just what it sounds like – you record receipts when the money arrives in your door, and you record expenses when you sign the checks (or in the case of one client who previously only recorded those checks when they showed up on their bank statement). Then your accounting software produces the standard reports – income statement, balance sheet, etc. whenever you ask for them.
A couple of small problems:
- If you sell your products and services to customers to whom you have extended credit (assuming you’re not the corner candy store that only deals in cash) your customers owe you money. But your financial reports don’t tell you how much money they owe you. You’ll have to run a separate report to get that, or keep a record somewhere else. Oops, just got a little less simple.
- If you buy the products you sell on credit, you typically get 30-day terms to pay those bills. But knowing how much you owe and to who, so you can make sure cash is in the bank when it’s time to pay them, sorry, you’ll have to run a separate report, or keep a spreadsheet or some other record – perhaps a stack of unpaid bills on the corner of your desk. Oops, just got even less simple.
- Your company will often buy things that last longer than the time period between financial reports – inventory that you’ll sell over the next X months, insurance premiums and property taxes that provide value for a year, etc. If you want your financial report to show a real gross profit on your sales, you have to separate the goods you bought and sold from the goods you bought and haven’t sold. Holy Moley, we’re way past simple now. We’re in a quagmire of disinformation.
- And to top it all off, your bank won’t lend your company money until they know the answers to those questions as well. You can send them all those separate reports and assure them they’re accurate even though they can’t reconcile them to anything, and they’ll trust you. Or maybe not.
My list of problems is only limited by the intended length of this post. So if you need to hire an accountant for your company, and the interview process brings up the question of accounting practices – as it should – you might ask them how they would feel about keeping your books on the cash basis, “to make income tax reporting simpler.” Then listen carefully to their answer.
We are Your CFO for Rent.
