You didn’t start a business so that you could learn accounting, but learn you must! Here’s a little help.
QuickBooks lets you switch between two radically different methods of accounting with a click of a button. It’s nice to have accommodating software, but which one should you pick?
Never heard of either of these? Time to learn:
“Cash-Basis” accounting means you only count revenue and expenses that you actually have. Things that count: Receiving a check or credit card payment, writing a check to the telephone company, paying your credit card bill. Things that don’t count: Receiving a purchase order, receiving the bill from the telephone company, charging something on a credit card. So it counts only if real, hard cash comes in or goes out. Stuff that hits a bank account.
“Accural-Basis” accounting means you count pledged revenue and expenses. It’s the opposite of cash-basis — what counts are purchase orders (customers pledging to pay you), bills arriving (vendors you’re pledging to pay), and credit card purchases (debt you’re incurring). It doesn’t matter when you pay the bill or when the customer actually sends you a check.
So which should you use?
Which is better for paying taxes?
The IRS allows you to pay taxes with either style of accounting, but you want to use cash-basis.
You have to pay taxes with cash. With cash-basis accounting, you show a profit only if you have excess cash actually in your possession. If it’s in the bank, you can set it aside for taxes. It’s like a dagger through the heart, but you can afford it.
Not so with accrual-basis. If you get a huge purchase order from a new customer, that would show as income; then the IRS wants their 30%, but since the customer hasn’t paid (and you, silly silly, paid your bills on time), you don’t have the cash to pay. Oops!
Cash is king, much of the time.
You’ve probably heard “cash is king:” Real cash (not purchase orders) pays your mortgage, keeps the internet up, and pays employees. Bills can be paid late, but they don’t take “accounts receivable” at the grocery store.
Thus for daily operations, cash-basis wins again. When you’re deciding whether you can afford a new advertisement, whether your payroll check is going to bounce, or whether you can actually take some cash out for yourself this quarter, you have to use cash-basis.
Which is better for understanding how the business is doing?
So far cash-basis has won every time, but when you shift your attention from daily operations to business analysis, cash is not king.
Here are questions best answered using accrual-basis accounting:
- Am I taking in more money than I spend? (How close? How is it changing?)
- Am I staying inside my own budget?
- Which expenses are eating my lunch?
- Are there unexpected expenses?
- How do I build a budget for the next six months?
Let’s take the first question as an example. Revenue-versus-expenses is important for every business at every stage of its life; no duh. What you’re really comparing is “revenue won” versus “expenses incurred.”
The trouble with cash-basis accounting is that it has nothing to do with when you incurred the expense, but rather when you paid the bill. You might have paid late (on purpose or otherwise). You might have paid early for a discount. The bill might have appeared on weird days so it just so happens that you paid a monthly bill twice in March and skipped April. Same with revenue — at Smart Bear it was common for a purchase order to be paid 5, 30, or even 90 days late. We won the order — the marketing worked, the sale was approved, tech support satisfied the end users — but who knows what in month the revenue would actually hit the bank account.
With the bulleted questions above, these cash-basis variances hide the important story. You need to measure intent, not the chaotic reality of money moving around.
Jason’s Scaredy-Cat Method:
Cash-basis revenue + Accrual-basis expenses
I’m conservative and pessimistic by nature. Yeah, I know, not adjectives you’d normally associate with someone who starts companies instead of holding down a job, but that’s not news. And since I don’t have an online accounting degree, I need something simple.
So at Smart Bear I combined the worst of both worlds to build a safe model of how much money I could afford to lose on experiments. Why this peculiar cash/accrual split?
- Revenue only counts when the cash is in the bank (cash-basis). I’m uncomfortable incurring expenses when I don’t know when or whether a customer will pay. Collections are uncertain; I won’t depend on a dollar until they can’t take it away from me.
- Expenses count immediately (accural-basis). I’ve incurred the cost, so for planning purposes I have to pretend that cash is gone. Sure some cash-revenue might appear before the bill is paid, but it might go the other way, causing a temporary cash-poor condition.
This isn’t always an appropriate method. It’s bad for budgeting or forecasting because you’ll underestimate what you can afford, so for example you’ll unnecessarily limit marketing efforts. It’s bad when you’re getting your arms around the “revenue versus expenses” example because you’re not comparing the same kinds of money.
But this method is perfect when pondering an experiment. It’s perfect when you’re wondering if you can afford $5000 in graphic design work, a new $6500 marketing campaign, or whether you can hire someone and have 3 months of runway to discover that was a massive mistake.
It’s right for experiments because with this method you know for certain that even if the new effort is a colossal failure, you really can afford to lose that money.
More advice, more methods
What other methods or advice do you have for the intrepid entrepreneur who just realized she has to know something about accounting? Leave a comment and join the conversation.