Often, I’m told by a business owner that they don’t understand why their financial statements show strong profitability for two or three months, and then — suddenly — they have a month with a significant loss. They have stable sales, but the highs and lows of profitability are confusing.
You don’t need to be a CPA to understand cash versus accrual basis reporting, and it’s important for any business owner to understand the difference.
Often business owners follow the way their accountant does their taxes. This can give them a misguided view of their profitability. If your CPA does your taxes on a cash basis, they want you to pay taxes on the money that you’ve received. But your financial statements should show profits based on the sales you made.
Here’s a simple example:
If your business had only one customer, and you sold them $10,000 this month with a cost of $6,000, you made a $4,000 profit — on an accrual basis. Your costs are aligned with the sale you made, easily identifying the profit on that sale.
If you were reporting on a cash basis, your reports would show the movement of the money. So, in this same example, you sold $10,000 of product this month, but your customer paid you nothing. You paid your supplier $6,000 for what you bought. Your sales for this month were $0, because you received no money, but your expenses were $6,000. You had a $6,000 loss. Next month, your customer pays you for what they bought this month, but you pay no bills, because you paid your supplier this month. So, next month, you will receive $10,000, but pay no money out. Wow, you will make a $10,000 profit!
Accrual reporting shows you the profitability on your actual sales. Cash reporting shows profitability based on the money you’re received and paid out. Accrual reporting actually reports your profits from operations. Cash reporting reports how money has flowed through your bank account.
If you’re still confused, reach out to us. It’s important that you understand these differences.
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