While not every business follows or, for that matter, needs to keep their books on an accrual basis or in accordance with Generally Accepted Accounting Principles (GAAP), I believe it’s very important for everybody running a business to know what the differences are. Let’s start with an example.
You sell a joke-writing service to accountants, CPAs and CFOs at a cost of $1,000 per month. You and your humorless clients agree to annual billing. On January 1, the beginning of the 12 month period, you bill your client $12,000, and your client pays you on February 1. When should the revenue appear on your Profit & Loss Statement?
Companies that record revenue based on billing show $12,000 of revenue in January. Companies that record revenue based on cash received show zero revenue in January and $12,000 in February, and companies that record their revenue on an accrual basis would show $1,000 of revenue in each month January through December. This is because only $1,000 is earned each month during the 12-month contract period.
Similarly, if your company does project work, your earned revenue on an accrual basis is based on hours worked that month multiplied by the applicable hourly rates or the percentage of the project completed if it’s a flat fee project.
While there are nuances to the recording of revenue under GAAP which I don’t go into here, the basics above apply to most situations. If you’re not recording your revenue in this manner, why does this matter?
- While cash is king, bankers and investors (both current and potential) will likely want to know how the company is performing on an accrual basis.
- If you’re looking to sell, potential buyers are likely to want to see or convert your revenue to the accrual basis so they can better analyze your business.
- You should be looking at your business from both a cash and accrual perspective. While recording revenue based on billing or cash receipts is common among SMBs, you could be missing trends, skewing profit margins (both gross and net) and not paying enough attention to collecting receivables.