In collaboration with: Bill Waters
Accounting is the language of business, and as a company evolves, so too does the accounting practices. Many companies start on the traditional cash accounting principle, which simplifies how revenue is recorded. However, there are a range of benefits to moving to accrual accounting to give better insights into the health of the business. Let’s compare cash and accrual accounting and how you can move towards a more sophisticated accounting practice at your company.
Under the cash accounting method, revenue is reported on the income statement only when cash is received, and expenses are recorded only when cash is paid out. Cash accounting is common for most new businesses that seek to manage transactions and cash based on what is currently available. However, cash basis accounting is not compliant with Generally Accepted Accounting Principles (GAAP).
Under the accrual based method, revenue is accounted for when it is earned. Unlike the cash accounting method, the accrual accounting method records revenue when a product or service is delivered to a customer with the expectation that money will be paid in the future. In other words, money is accounted for before it's received. Likewise, expenses for goods and services are recorded before any cash is paid out for them.
So when and why should you switch from cash to accrual based accounting at your organization? First, consider the major benefit that accrual based accounting provides a better indication of how a business is performing, because it shows when revenues and expenses were incurred.
For example, if you are a manufacturing company that produces widgets and sells them to customers directly, but the payment terms on the invoice gives the customer 30 days to pay, you would record the revenue at the time you sold the widget. If you have hundreds of customers waiting three weeks to a month to pay for the widgets, the view of the business at a certain point in the month prior to those payments being processed would give a false impression that your company’s sales, revenue and income are significantly lower when using a cash accounting method.
Accrual accounting does add a layer of complexity to the accounting process. Still, with the right blend of expertise, processes and technology, the transition can be facilitated - including your historical data. It also makes the relationship between revenue and expenses more transparent and offers a more accurate view of a company’s assets and liabilities.
Since accrual accounting reflects future cash flow, it enables more accurate strategic planning for FP&A teams. It provides a clearer, and more accurate picture of the performance of the business, which allows business leaders to analyze trends, budget and forecast more effectively. Instead of worrying about when payments will be received and when expenses will be paid, accrual accounting records these transactions immediately, giving greater clarity into cash in and out.
One of the biggest impacts of making the switch from cash to accrual accounting is how transactions are booked in the general ledger and accounting software. Accrual-based accounting requires various asset and liability accounts not necessarily needed in cash based accounting, such as accrued expenses, accrued payroll and prepaids. These accounts should have their own reconciliation and tracking to ensure accuracy.
You don’t have to be a large enterprise to turn to accrual accounting either. Cash accounting can work for small companies, with no inventory, minimal stakeholders and not analyzing at a deep level. The reality is most companies should consider using accrual accounting. In cash accounting, it is very easy to manipulate financial results, by simply delaying payments or deposits. It simply does not provide accurate financial insight into an organization to act on.
When it comes to FP&A, accrual accounting lends itself well to facilitate detailed analysis. For example, Software-as-a-Service (SaaS) companies can use accrual accounting to help distribute revenue and expenses, which makes it much easier to analyze financial health and forecast.
Since SaaS companies typically charge on a monthly or pre-paid annual subscription, the accrual accounting method enables them to calculate monthly recurring revenue (MRR) as a deal closes, which is beneficial for forecasting, valuation and planning purposes.
These principles can apply to any industry that has a recurring revenue stream, not just software. In particular, accrual accounting can help FP&A:
In general, accrual based accounting can be more difficult to manage, and requires additional work to prepare reconciliations and journal entries to manage accruals and prepaids. Oftentimes, finance and accounting teams consider a new, more advanced accounting software or enterprise resource planning (ERP) system; however, the type of accounting software you use is not indicative of the ability to leverage the accrual based accounting method.
Instead, more capable ERP systems can be considered when you are in need of multicurrency management, have a complex chart of accounts structure and transaction nuances, and need to consolidate multiple entities.
The FutureView Platform is capable of preparing entries and reconciliations in a more automated fashion, including taking cash based financial statements and transforming them into accrual based financial statements. However, our general advice is to have these entries made in the general ledger such as QuickBooks Online, Sage Intacct or NetSuite, and leveraging the FutureView Platform for reporting, budgeting and forecasting purposes.
If you’re considering a move from cash to accrual accounting, our team of accounting and finance experts are available to not only consult with you, but provide tactical support to facilitate the transition, while implementing FP&A tools and solutions to extract strategic value from your data.