It's no secret that business owners like the cash method that we talked about in the last post. It's easy to do, however it’s not accurate in representing what your company actually did. Some small business owners groan at the idea of switching over to accrual accounting and to them it's a cruel way to go. But who says it has to be hard? Today, we are going to talk about what accrual accounting is, and then tomorrow we will get into how to make it work for your business.
The goal of accrual accounting:
Accrual accounting allows you to record in your books when a transaction occurred, not when the cash was received or paid out. So, let’s talk about how this affects revenue first. Let's go back to pops lawn shop for a handy example. If they were to mow your lawn today, they would have performed a service that gives them a right to receive revenue. Regardless of whether or not you paid them cash or paid them in a week, the lawn mower would go back to the office, tell the bookkeeper and the transaction would get recorded right then and there. In this situation, there are two ways to record the transaction:
1. If you paid cash today, the bookkeeper would increase the cash account (debit) and increase the revenue account (credit).
2. If you didn't pay today, the bookkeeper would have to record a receivable from you. The entry today would be to increase accounts receivable (debit) and increase revenue (credit).
Notice that in both situations we are increasing revenue. That is because the revenue was earned today.
Why is this important you ask?
Your books should paint a financial picture of your company's performance. As a business owner, you need to know when your revenue was earned so that you can better see how the company is performing and therefore make better decisions.
Let's look at expenses now:
Let's say that Pops lawn shop has to pay for workers compensation insurance for all of their employees working around dangerous equipment. To make things exciting, let’s say that the company only pays for the insurance once a year on January 1st. How do you make that entry? Well, under the cash method, you would have recognized the entire expense on January 1st because that was when the cash was paid out. You would have increased your insurance expense (debit) and lowered your cash (credit) because you paid out money for the stuff. Easy enough right? It is, but it doesn't speak to what actually happened. The employees of pop's shop didn't use all of that insurance on January 1st and then go uncovered for the rest of the year. No, they used it every day. So, to paint the right financial picture, you should slowly expense the money paid over the entire year.
Here is how that would work:
January first rolls around and Pops insurance agent says, hey you owe $1,200 for workers comp for the coming year. Pop would then have to pay the full $1,200 upfront and the entry would look like this. He would Increase a prepaid expense account (debit) by $1,200 and lower cash (credit) by $1,200.
Now you’re thinking, “oh great, a net term. What in the world is a prepaid expense account?” Well, it’s an asset account on your books. It says to whoever is looking at the books, "hey, we paid upfront for a service that has not been completed yet". It's like putting money aside for a certain need the business has.
You may be asking, “Why are we not expensing any of the insurance? Workers compensation is an expense right?” Yes, it is an expense, but on January 1st we haven't used any of it because the year has just started.
Once January is over, we will have used one month's worth of our insurance that we paid up front for. Now we do a new entry. At the end of the month we will increase our workers compensation expense (debit) by $100 and decrease the prepaid expense account (credit) by $100. The $100 comes from the fact that we paid $1,200 upfront and we have used one month’s worth, or $1,200 / 12 months = $100 per month.
Now we are painting an accurate picture. When you look at your financial statement, you as the business owner will be able to say, "I have used up part of my insurance, and it looks like I am covered through the rest of the year. I can also see how much insurance was used during January.”
Although it’s more work, accrual accounting is the way to go. If you have a certain situation that your company is dealing with, feel free to respond to this post with your questions and we can talk about it.
Remember to check out tomorrow’s post. I love looking at practical things a business can do to implement this stuff, and that is just what we will be doing. I want to explore ways that a business can set up their accounting so that this accrual thing is actually easy to do.
Good luck!
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