Last week we talked about timing and making sure that certain costs were entered when they are relevant. This is a very difficult territory for some and confusing for others.
I am going to try to make it simple (and I hope I’m able to do so!)
First let me refresh your memory on the difference between cash and accrual accounting.
If you are in the US, you have to pick a standard by which you do your books. Most small businesses report their Income and Expenses to the IRS on a Cash basis, but a cash basis is not always the best for internal reporting and figures.
Here’s a brief explanation of Cash Basis accounting: Money is earned when it is received, not billed. Expenses are classified as expenses when they are paid out, not when the invoice is received.
So, in other words you send an invoice to ABC, Inc. in November and they pay you in February. It is income in February not November.
Or you get a bill from the phone company in January and you pay it in March, it is an expense in March, not January.
Having your IRS reported basis as Cash is comfortable for many businesses and you assure you only pay taxes on what you actually ‘receive’.
However, in daily business operations, it is not the best way to go. I mean, think about it: If you created a website for a client, let’s call him John, and you bill him the $1,000.00 in January once the website is done, but he does not pay until February. Then the graphic designer you had working on John’s design cost you $400, but he billed you in February, but you don’t pay him until March.
If you use Cash Reporting it looks like this:
|Income: $0||Income: $1,000.00||Income: $0|
|Cost of Goods Sold: $0||Cost of Goods Sold: $0||Cost of Goods Sold: $400.00|
|Profit: $0||Profit: $1,000.00||Profit: -$400.0|
This is of course pretending those were your only business income and expenses. However, you see the issue. January has nothing, when it should have $1,000.00 income, $400.00 Cost of Goods Sold and $600.00 profit. Whereas February and March have figures that should not exist.
In the grand scheme of things your Net is still right, but it does not help you for monthly planning and budgeting.
Now, using a robust accounting system such as QuickBooks can rectify this situation because you can enter everything accordingly and change your report type from ‘cash’ to ‘accrual’ and back to ‘cash’ as needed.
However, there are plenty of things you need to be aware of in order for the system to report correctly.
1. Make sure you enter an invoice. Don’t just enter a direct income when the monies are received. Make sure you enter an invoice with a date in the month that the actual sale transpired.
2. When you receive monies up front, such as a deposit, don’t enter those as an income, because they are not. These are monies held in trust. Create a liability account called “Deposits on File” or “Monies in Trust” and record the deposits there. This will let you have it in your books (i.e. in your bank account) but clearly show that it is not earned yet; it is a liability (meaning you owe this value of money or services to someone). Once you do invoice them, you can apply these monies.
3. When you pay for something in advance, don’t just enter it in one lump payment. For example, let’s say you paid $12,000.00 in rent for $1,000.00 a month for 12 months. Don’t enter it all in January as rent, because then you have overstated expenses for January. Set up an asset account called Prepaid Rents, and every month transfer $1,000.00 out of the asset account and put it in the rent account. This way you can document that the $12,000.00 went out of your bank account and into another “asset”, but it was not actually an expense of $12,000; rather it was $1,000 a month for 12 months.
4. When you get a bill, don’t put it in a box and wait for it to be paid. Enter the bill as an accounts payable using the date the bill was generated (or better yet, service performed). That way you have it on the books in accrual format and it is there to mark “paid” once you actually do part with the cash.
Performing your bookkeeping this way will assure the following:
1. You never over-report your income or expenses to the taxing authority when reporting in cash basis and you will pay the proper taxes.
2. You will always have clear financial statements by month, showing the real income and costs per month when reporting in accrual format.
3. A quick look at your books and you will always know what you have or what is coming (assets) and what you owe (liabilities).