Financial statements provide deep insight into the health of a business. Whether underwriting a loan, onboarding a customer, or considering an equity investment, there’s no better way to start drilling down to the nuts and bolts than reviewing the company’s financials. Prior to gaining that insight, however, it is critical to understand how the financial statements were prepared.
When reviewing financial statements, it is critical to understand how the business classifies their transactions - either using Accrual Accounting principles or Cash Accounting principles.
Cash Accounting
Cash accounting is quite simple - transactions will show up on the financial statements at the same time they show up in the bank account.
As an individual, you may review your budget periodically by downloading your bank transactions. You can group all of your expenses by the transaction date and come up with categories like “groceries”, “rent”, “income”, etc. This is cash accounting at its core - the transaction shows up on your budget at the time that it shows up in your bank account.
Many small companies use cash accounting because of this simplicity. It’s a completely valid form of accounting for businesses under a certain size - even for filing taxes. That said, there are certain situations where cash accounting doesn’t paint a good enough picture of companies’ financial standings.
Let’s look at a brief example.
There was a car wash in my hometown that would sell annual subscriptions: they would take payment all at once and allow you to wash your car there throughout the year. People would often give these annual subscriptions as gifts for family and friends at the holidays in December. December revenue was huge! A bunch of their customers were paying for 12 months worth of car washes that month. The rest of the year, though, their business was incurring a ton of expenses from paying employees, water bills, and supplies without receiving additional income to their bank account. If you were evaluating the car wash business in December, you’d see a huge winner. In June, though, this business would look like it was going under!
Like the car wash, companies with large inflows or outflows of cash related to long periods of time (like prepaying for 12 months of car washes) will be able to communicate the health of their business more clearly using accrual accounting.
Accrual Accounting
Accrual accounting is more complex but more accurately represents the health of companies with complex operations. It is required for filing taxes if revenues exceed a certain limit. Additionally, it is the standard outlined by the Generally Accepted Accounting Principles (GAAP).
The core concept is that transactions impact financial statements at the time that goods or services are provided.
Let’s return to the prior example:
The car wash would likely want to show the revenue from their annual subscriptions on their financial statements over the course of the entire year instead of just in December. This way, when someone evaluates the business in June, it doesn’t appear to be unprofitable. In reality, the business is still doing the work in June that is associated with the money that was deposited into the bank account in December. Thus, it is appropriate to show a portion of that revenue while it is being earned in June.
A company like this car wash may go through the effort of generating accrual-based financial statements if:
- A bank / investor requires it when raising capital or selling the business
- The company operates with large stocks (e.g. inventory, equipment)
- There is significant duration between cash flows and date of service
Hybrid Accounting
Enter, the gray area. The reality is that many businesses that are not required to use accrual accounting may use a hybrid accounting framework.
Hybrid accounting frameworks draw on a combination of cash accounting and accrual accounting principles, using accrual where it makes sense for better communicating the business health and cash where the additional accounting overhead is not worth the effort.
What about our car wash?
The car wash would likely want to recognize revenue using accrual concepts, as discussed. Yet, they have many other transactions that are much smaller and less seasonal. Their water bill comes every month and varies slightly. Often the bill paid in a given month, say March, actually covers the prior month’s usage, say February. Using proper accrual principles, the car wash would reflect the expense for the water bill that they paid in March on their financial statements in February (since this is when the expense was incurred / the goods were used). In reality, the water bill doesn’t vary enough for it to make a big difference for the financial statements - so the car wash just uses cash accounting principles for this expense item. So, here we have accrual-based revenue and cash-based expenses: this car wash is using a hybrid accounting framework.
Notably, as long as a company is consistent with their treatment each year, this is an acceptable methodology for tax filing purposes. So the car wash is good to go with this treatment in the eyes of the IRS.
Summary
Cash accounting is simple and financial statements built on cash accounting principles can be derived directly from bank statements. Accrual accounting is a more accurate view of company’s performance, but it is more difficult and requires a deeper understanding of the business operations to prepare financial statements.
Large or complex companies will likely use GAAP accrual accounting, while small companies will likely use cash accounting with some accrual concepts added in where it makes sense for them.
At Basis, we’re focused on drawing deep data and insights directly from authoritative sources, like bank accounts, in order to draw out the business context required to construct cash-based or accrual-based financials.