Reading your Financial Statements (2 of 3)
Before you can begin to analyze your financial statements, you first have to understand the rules, or methodology, by which they’ve been prepared. We call this methodology an accounting basis. In general we have two bases, the accrual basis of accounting, and the cash basis of accounting. Even within these two methodologies, there’s a lot of wiggle room (subjectiveness). In order to try and solve the problems that come with subjectiveness, certain authoritative and governing bodies create frameworks and standards. For instance, in the U.S. public companies are required to issue financial statements using GAAP (which stands for generally accepted accounting principles). GAAP are standards built around the accrual basis methodology. Conversely, most small businesses file their taxes using the modified cash basis of accounting, using tax basis standards.
In general, the accrual basis of accounting provides us (as interest parties) with a lot more information than the cash basis of accounting. That’s because it doesn’t just show us cash received and disbursed, it tries to show us actual performance.
Revenues, for instance, are recorded when they’re earned, rather than when they’re collected.
Likewise, expenses are recorded when incurred, not when they’re paid.
Most standards surrounding the accrual basis of accounting, also use the matching principle. The matching principle makes it so you have to record expenses, that are directly or indirectly related to your revenue, in the same period as said revenue. The end result is a more reliable and consistent profit margin.
If you’re a non-accountant, chances are you’re thoroughly confused right about now. That’s ok, stick with me because I’m going to make it explain in a more practical sense by showing you what an accrual set of financial statements has in it that cash basis financial statements do not.
Functionally, accrual basis financial statements have Accrual accounts and Deferment accounts on their balance sheet.
An Accrual is something that has been recorded BEFORE cash has exchanged hands. An example would be Accounts Receivable (or A/R for short). The A/R account holds money that is owed to me. When I record Revenue on an invoice, my A/R account increases because my client owes me money. When my invoice is paid, my A/R account decreases because that money is no longer owed to me. While this is occurring on the balance sheet, I have already record that revenue on my income statement at the time it was earned. Similarly Accounts Payable (A/P) increases when I record an expense and owe my vendor money. A/P will then decrease when I pay that bill.
A Deferment is the opposite of an Accrual. A Deferment is when I recognize a transaction AFTER cash has exchanged hands. Examples of deferments are Prepaid Expenses and Unearned Revenue. I hold transactions in those accounts until a future date when it is appropriate to recognize the expense or revenue.
It might sound like there’s a lot of room to manipulate earnings by using Accruals and Deferrals, because there is. And that’s why there extensive standards and frameworks outlining when it is and isn’t appropriate to accrue or defer something.
Modified Cash Basis
For all intents and purposes, the cash basis of accounting is a much simpler basis of accounting. On cash basis you record revenues when your clients pay you and you record expenses when you pay your vendors (SIMPLE!). However, cash basis is less transparent than accrual basis accounting because, for instance, if I wanted to overstate my income all I would have to do is hold off on paying bills. That’s not good for an interested party like a bank or investor because they want to know what you owe your vendors and what your true profits are. That being said, the (modified) cash basis of accounting is popular amongst small businesses because small business owners prefer not to ever be in a situation where they have to pay tax on income they haven’t yet received.
In practice, taxpayers typically use a MODIFIED cash basis of accounting. The difference between true cash basis accounting and modified cash basis accounting is that modified cash basis allows you to include certain accruals. Common accruals relate to long-term fixed assets (also call Property, Plant, and Equipment), long-term and short-term debt, tax liabilities (especially sales tax or payroll tax), and employee benefits like retirement contributions.
Businesses reporting in Modified Cash Basis do not include Accounts Receivable or Accounts Payable on their financial statements.
It’s important to understand the distinction between cash and accrual basis because it’ll properly frame the way you read financial statements. I often look at clients’ financial statements, that were prepared by an outside bookkeeper, and notice an A/R or A/P balance (sometimes even a negative balance), and the financials are supposed to be on cash basis; that’s a red flag for me, and more often than not, the financials are not accurate.