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Recently I have met a number of business owners who have made a decision to run their books on a cash basis.  Surprisingly, these are not “mom and pop” companies, but have revenues exceeding several $million. They explained that things had been very bad over the last few years and that this was the only way they felt comfortable managing the business. 
As a CFO I don’t agree with this approach – it’s a little too much like the old jam jar accounting process where you set aside cash amounts for expense categories, and when the jar is empty – you are done, at least until the next pay check.  Let’s just make sure we understand what is happening.

Cash Basis

If you use the cash method of accounting, you record income only when you receive cash from your customers. You record an expense only when you write the check to the vendor. Most individuals and many new companies use the cash method for their personal finances because it's simpler and less time-consuming. However, this method can distort your income and expenses, especially if you extend credit to your customers, if you buy on credit from your suppliers, or you keep an inventory of the products you sell.

Accrual Method With the accrual method, you record income when the sale occurs, whether it be the delivery of a product or the rendering of a service on your part, regardless of when you get paid. You record an expense when you receive goods or services, even though you may not pay for them until later.
Accrual accounting is required by GAAP standards  - the "Matching principle" requires expenses to be matched with revenues as long as it is reasonable to do so.  This principle allows greater evaluation of actual profitability and performance (shows how much was spent to earn revenue).
The accrual method gives you a much more accurate picture of your financial situation than the cash method. This is because income earned in one period is accurately matched against the expenses that correspond to that period, so you get a better picture of your net profits for each period.

Pros and Cons.
The cash method is maybe easier to maintain because you don't record income until you receive the cash, and you don't record an expense until the cash is paid out. But Cash basis accounting does not conform to Generally Accepted Accounting Principles (GAAP) rules – since revenue and expenses are not matched, and there are specific IRS rules that specify that companies of a certain size cannot use the Cash Basis for tax purposes. If you maintain an inventory, you will have to use the accrual method, at least for sales and purchases of inventory for resale.

The accrual method gives you a more accurate picture of your financial situation than the cash method.   For a larger company using cash basis accounting and requiring audit, there will be additional audit costs associated with converting the company to an accrual basis.

The core problem with Cash basis accounting is that you lose the ability to manage the business pro-actively.  It’s like checking the bank account every week and making spending decisions based on the bank balance.  Without an accurate picture of true revenue and expenses, how can you understand profitability – of products and people?  How can you identify collection problems, and weaker customers.  How do you take advantage of vendor credit? How do you explain your business to the bank, and give them a comfort factor that you have control?  How do you forecast cash flows six months out?  In short, how do you get peace of mind?

So how can we address the genuine concern about managing cash flows that has caused some companies to adopt a cash basis approach?  The solution is financial visibility.  There is no reason why a company cannot manage cash flows very tightly, while having the advantages of Accrual accounting.  Weekly and monthly cash flow forecasts are essential, financial dashboards will help to visualize and track key metrics.  Detailed long term budgets and plans will help the business predict the future, and determine what contingency plans are needed.  Planning cash flow is the most effective way to ensure that additional funding is available when needed.

A B2B CFO is an affordable way to develop more financial visibility.  Call David Kirkup, Partner with B2B CFO on 404 348 0326 or dkirkup@b2bcfo.com.