Imagine that you have the opportunity to invest in a company. The current owner paints a very bright picture of the company’s future. He says that the company has been so busy that current employees can't keep up with sales. As a result, the company needs cash to continue to grow. The company’s income statement looks too good to be true as it shows a lot of revenue and very few expenses. (You’ve discovered a cash cow!)
You start to get a little skeptical when you notice that the balance sheet doesn’t include any liabilities. How can a company that needs cash not owe anything to vendors? Some things he mentioned don’t seem to match what the financial statements are showing. Although he referred to employees, wages on the income statement seem really small. Many other costs that you'd expect to see aren't recorded.
You begin to question the owner regarding how he was able to sell so many items with so few production costs. To your surprise, he responds that many customers have paid the company in advance for items that haven't yet been manufactured. As cash has been received, he recorded these amounts as sales. This seems a little deceptive. Don’t you have to deliver something before you can record it as a sale?
Doubting the financial information, you ask how the company has recorded so few expenses. When asked about wages, he responds that the employees have been “very patient”. The owner has promised to pay the employees what he currently owes them when he is able to get some investors. You ask him about amounts owed to vendors and he tells you that companies have continued to deliver supplies and provide services although the company is behind in paying some of them.
Something doesn’t seem quite right. The company owes money to employees and vendors, but the financial statements don’t show these amounts anywhere.
Thinking it over, the financial statements don’t really give you a true picture of the company’s financial results. If wages were recorded when employees worked and other expenses were recorded when items were received or services rendered, this company might not be profitable. Disillusioned with this potential investment, you ask the owner how he can tell whether the company is really earning a profit with his current accounting. He quickly retorts that he knows he is making money because the company has more money in the bank than it did a year ago. As he leaves, he mutters to himself that you obviously don't understand “cash basis accounting”.
So who was right – you or the current owner? Believe it or not, the business owner may not have been trying to deceive you. He might be putting too much faith in a substandard accounting method – the cash basis of accounting. Under the cash basis of accounting, revenues are recorded when cash is received and expenses are recorded when cash is paid. The story shows the biggest problem with the cash basis. The resulting financial statements don’t adequately show how much the company owes as most liabilities aren’t recorded.
An important idea in accounting is called “the matching principle”. Basically, this is the idea that expenses should be recorded when an obligation is incurred. Also, when a company records a sale, the expenses required to make the item or to provide the service should be recorded in the same period. It doesn’t matter when the cash is paid. This is the foundation for accrual accounting.
So which is better – cash or accrual accounting? Well… it depends. One benefit of cash basis accounting is that the business has more control over when it will record revenue and expenses. The IRS allows many small businesses to use the cash basis of accounting. This enables small business owners to reduce their taxable income by doing things like prepaying expenses and purchasing supplies right at year end.
While it can help reduce taxable income, this ability to manipulate income is the big downfall for cash basis accounting with potential lenders and investors. They are right to be skeptical of cash basis financial statements. The benefit of accrual accounting is that it provides more useful and reliable financial information. Accrual basis financial statements provide a better view of the company’s current financial results and the future earning potential of the company. When you put together a business plan, you want to put together accurate projections of the company’s future and this is the reason that enloop uses the accrual basis of accounting.