Accounting For Your Business

Cash-basis Accounting

What it is: recognizing only those transactions that affect your cash balance. This method recognizes business activity only when money changes hands (cash, checks, or bank debits/credits). A sale is a sale when the customer pays you, a purchase is an expense when you pay for goods, and income is the net change in your cash balance for any given period. This method produces only an income statement and is very simple to operate.

Who can use it:service businesses like gardeners, trainers, bookkeepers, etc., or professionals such as doctors and lawyers. Any business that does not carry inventory may elect to operate under cash-basis accounting. Its primary benefit is to delay the recognition of taxable income for future years so you can use that money now and pay it to the IRS later (hopefully, with inflated dollars).

What if your business is primarily a service but you also sell some related products to your customers? If those sales are “material to the business” in the eyes of the IRS, then you must use accrual accounting. Review your particular situation with a qualified professional and be aware that the IRS has the final say in this area. To be safe, use accrual accounting.

What to watch out for:

1. Incidental product sales may be classified as “inventory” by the IRS, requiring you to restate your results and recalculate the income tax due.
2. You will have to establish a separate method to track amounts customers owe you and amounts you owe to others.
3. Because it does not match revenues to expenses for the reporting period, cash-basis accounting is not a generally accepted accounting principle (GAAP), and GAAP compliance is typically required for bank loans and outside investors.

Accrual Accounting

What it is: recording every transaction “as it happens” whether or not cash is involved. This method records every business activity even though the events have not been consummated by the exchange of cash. This includes the recording of events based on the exchange of goods and promises made (purchase and sale agreements), as well as the simple passage of time (interest and depreciation calculations). Financial statements generated with this method include the income statement, balance sheet, and statement of cash flow.

When to use it: Any business may elect to use accrual accounting, but the IRS dictates that companies that carry inventory must use it. Without this requirement, a company could buy lots of inventory at the end of each year to reduce its income and pay less total tax. Accrual accounting is also the method sanctioned by generally accepted accounting principles.

What to watch out for:

1. Be careful to distinguish “income” from “cash” by understanding which transactions appear in the income statement and which show up on the statement of cash flow.
2. Establish periodic entries for “non-cash” transactions (i.e., interest, depreciation, amortization of prepaids, reclassification of deferred items, etc.).
3. Be clear about cut-off dates for the closing of each accounting period.

Implications of Your Choice

Selecting an accounting method: When setting up a new company, you must determine which accounting methods are available. If you will carry inventory, the answer is simple: You must use accrual-based accounting. Service companies have the option of cash or accrual methods and should examine their financial goals to see which method will produce the desired results (to minimize taxes or generate profits). Discuss this topic with your CPA or tax accountant before setting up your accounting system.

Changing your mind: The IRS allows companies using cash-basis accounting to switch to the accrual method because it will, most likely, generate higher income taxes. Once you are using the accrual method, however, you cannot switch to cash-based accounting. Companies that begin using the accrual method are not allowed the option to change, either.

Book vs. tax accounting:Companies that qualify for cash accounting can also elect to use the accrual method. They may also keep their books under both methods, using cash-based accounting for tax reporting and accrual accounting for reporting to investors, banks, and management. The option to change your tax accounting method from cash to accrual is still available but, once made, cannot be rescinded.

Resources for further study:

Nikolai , Loren A. and John D. Bazley. Intermediate Accounting. 9^th ed.Mason, OH: South-Western, div. of Thomson Learning, 2003. ISBN 0-324-18328-3

Recommended reading for the non-financial manager:

Mullis, Darrell and Judith Orloff. The Accounting Game.Naperville, IL: Educational Discoveries, Inc., 1998. ISBN 1-57071-396-0

Elaine Orgain is President and co-founder of Silicon Valley Accounting Solutions and can be reached at 408-260-5250 or via email at elaine@svaccounting.com.

“In business, cash is king,” asserts Fleisher. “If you run out of cash, the game is over. For that reason, you must attend to cash flow at all times. Unfortunately, most CEOs spend very little time looking at the cash flow statement. Instead, they usually dive right into the P&L to see how sales and revenues are doing. The P&L is an important document, but it only gives you a historical recording of what happened over a period of time. The cash flow statement tells you where you are now and whether you will live or not. For that reason, I strongly suggest looking at it before you review the P&L or the balance sheet.”It’s like coming to the scene of an accident. Suppose you’re a medic and you arrive to find a patient with a dislocated shoulder, a broken leg and nose, and a severed artery. What would you treat first? The artery, of course. Otherwise the patient could die. You need to treat cash flow the same way because it represents the blood flowing through your company’s veins. But most CEOs treat the broken nose (sales) because it’s sitting in the middle of the face.”

Reading the Cash Flow Statement

According to Vistage speaker John Zaepfel, the cash flow statement measures two vital indicators — how much cash you have coming in and how much is going out. It is typically broken down into three categories:

• Operating cash flow tracks the operational activities of the business that either use cash or generate it. It includes cash outflow to suppliers, employees, interest and taxes as well as cash inflow from customer receipts and interest dividends.
• Investing cash flow tracks discretionary investments made by management.
• Financing cash flow tracks cash activities having to do with financing the business.

Added together, these three categories determine the company’s overall cash flow. Like the balance sheet and P&L, the cash flow statement typically comes out once a month. However, both Fleisher and Zaepfel recommend going one step further and tracking cash on a daily basis, especially for companies having cash flow problems. To keep close tabs on your cash flow, say our experts:

• Review the cash flow statement once a month.
• Look at your receipts and disbursements on a daily basis.
• Know how much cash you have in hand and how long it would last if the money suddenly stopped coming in.
• Know how much working capital you will need for the next one, three and five years.

“It’s okay to look at the cash flow statement once a month as long as you track receipts and disbursements every day,” says Fleisher. “It only takes two minutes to review this information, but it will immediately raise red flags or put your mind at ease.”

While watching the daily cash flow is essential for survival, Zaepfel also warns against overlooking the long term.

“As companies grow, three things tend to happen,” he explains. “You outgrow your people, you outrun your system and you outrun your cash. You can fix the first two, but running out of cash will put you out of business. Unless you understand how much cash you will need to grow the business and plan accordingly, you may one day face insolvency when you least expect it.

“Most entrepreneurial companies are undercapitalized as they go through the growth curve. That’s okay in a good market, but it creates all kinds of problems when the market turns down. For that reason, you need to keep looking for capital and make sure your company is properly capitalized at all times.”

Strategies to Improve Cash Flow

To improve cash flow, Zaepfel and Fleisher recommend the following:

• Collect your receivables on time. Keep in mind that cash is not cash until it’s cash. Receivables are not cash; they are working capital tied up in receivables.
• Find out which day of the month your client companies cut their checks. Make sure your invoice gets there before that date, not after.
• Have your controller or CFO give you a weekly report indicating the top three outstanding accounts that have the most money past due. Work together to develop an action plan to get the money.
• Create an accounts receivable “Ten Most Wanted List” that includes the ten biggest accounts that aren’t paying on time. Make it a personal mission to collect on them.
• Eliminate any flaws in your invoicing and billing systems. Invoicing mistakes are a major cause for late payments.
• Negotiate performance-based incentives with your customers rather than giving immediate price concessions to speed up payment. If they buy a certain amount and agree to pay within 30 days, then they get a price break.

If you’re not collecting your receivables on time, find out why and make the necessary changes. Never settle for mediocre performance in this area.

• Negotiate better terms for your payables. The more time you have to pay, the longer you can stretch your working capital. However, cautions Fleisher, negotiate cost first and then ask for extended dating.
• Inventory. Strive to increase inventory turnover. Inventory equals cash sitting on the shelf.
• Focus on your sales mix. If you sell more high margin items, you will have more cash after paying expenses. Look for ways to increase incremental sales. If you can leverage more sales over existing costs, you will make more money and have more cash.
• Use performance-based compensation. Pay people after they get the results, not before.
• If it looks like layoffs are necessary, talk it over with your Vistage group sooner rather than later. It may be better to cut quickly and deeply to assure survival.

“Above all, constantly project your cash flow needs,” adds Zaepfel. “It’s not enough just to know how much is coming in and going out on a daily basis. You also have to know how much you will need tomorrow and where to get it. Otherwise, there may be no tomorrow for your business.”