When I took my Business courses in college, I noticed the good-natured tension between the professors in the more “creative” fields, such as Marketing, and the more “technical” fields, such as Accounting. The Marketing group chided the Accountants for being “bean counters” unconcerned with the actual branding and selling of the product – and you don’t need an accountant if you don’t have sales! On the other side, I had a favorite Accounting professor who sarcastically (and more than once) said that the Marketers specialized in “new and better ways to stock shelves”; he viewed Accounting as the heart and soul of understanding your business.
What does this have to do with Cash versus Accrual Accounting? It is illustrative of the need for a balanced approach in business. In the same way that a healthy business needs a clear, effective marketing plan AND a well-tuned accounting system to produce key performance indicators, a business owner also needs to understand his/her Cash Flow AND his/her profit margins. As we mentioned in Part 1 of the July series, the Cash Basis of accounting is often useful for tax reporting and for easily seeing the pure “cash-in, cash-out” activity in the business. However, owners should be careful not to become too wrapped up in “checkbook” accounting, which can easily lead to hesitant decision-making due to an incomplete understanding of the business profit model.
How are profits best measured? Accrual accounting is the answer, mostly because it follows the “matching principle” of accounting – this method matches Revenues and Expenses to the dates on which business activity occurred, not to the dates on which cash changed hands. The Accrual method is naturally more complex because it captures more information. By the way, in a previous post we have explained what is known as the UCA Cash Flow statement, which is a basic format that accountants use to convert accrued-based financial statements into a valuable cash flow analysis.
If you are a business owner, be sure that you review BOTH your accrued-based profitability and your statements of Cash Flows with your trusted Advisor, on a consistent basis. A solid understanding of how and when your cash moves is crucial to your ability to deal with your banker, your key vendors, and even your extension of credit to customers. Just as importantly, a proper accounting of your profits and margins is indispensable to your ability to make timely decisions and project your numbers out into the future.