Are you accounting for your revenue appropriately? I bet you're not, because I wasn't, and most of the people we work with aren't when we start working with them. Today, we're going to talk about the difference between cash accounting and accrual accounting. You don't want to miss this edition of the Inside B.S. Show.

Hey, I'm Dave Lorenzo, and today we're talking about the difference between cash accounting and accrual accounting. It's a Mentor Monday, and we're here with Harry Sandrowski. Harry, good afternoon, welcome back.

Hi, Dave. It's a great day. All right, so this topic is one that I'm sure you love.

It's one that I hate to talk about, because when I explain this to business owners, they tend to get very frustrated. So let's go very slowly, and let's start with what the difference is between cash accounting and accrual accounting. So very simply, cash accounting is just like what it sounds like, cash in, cash out.

So if you have $100 of cash coming in, and you actually paid $90 of expenses, that means your cash income is $10, right? So however, on an accrual basis, what happens, so like in our business, let's assume it was $100 and $90 and $10, but I billed out another $300 of invoices to my clients, okay? So then my accrual income would be $400, the $100 plus the $300, plus I probably have some expenses that I may have not paid. They could be legal bills, they could be commissions to my employees for bringing in work, it could be a variety of things. So the accrual basis is more of a matching of income and expenses, and that's why you can only use accrual accounting to have audited financials.

General Accepted Accounting Principles does not recognize cash as an acceptable method for financial states. So the idea there is you can really manipulate your cash using the cash accounting method for both financials and tax purposes. So isn't accrual accounting designed to smooth out the peaks and valleys in the reporting process? So you may get paid up front for all the work and the work is being done over 12 months.

If you get all that money up front, you can't recognize it as revenue all up front because the work hasn't been done. So you recognize the revenue when the work is done. You take the cash in and it sits there, and if you're doing 10% of the work every month for 10 months, then you recognize that percentage of the revenue as you continue to do the work.

Isn't that correct? Yes, that's generally correct. It's not going to be up to your contract, but if your contract says as you're doing the work, then you're entitled to the money. Generally speaking, that'll be the case even though you got all the money up front.

That's one way of looking at it. But the other way, as I mentioned, is a lot of times you bill for things that you've already done the service for, but you haven't collected. Accrual basis accounting will require you to accrue that income when you actually bill it.

Okay, so I do $100 worth of work this month and I've only billed for $20 worth of work, so I got to bill for the other $90 worth of work next month, but the work has already been done, so we recognize the whole amount of the work in that month. Yeah, the amount that you would invoice. Sometimes what happens, you might have put in all the work, and you might come back and say, you know what, I can only bill for 95% of it because the client's going to be price sensitive, so then you would just write that off and you don't only recognize the $95.

Okay, so at what point in a business, is it a size thing or at what point in a business do you switch from cash accounting to accrual accounting? Is it just a box I check in QuickBooks? Like what do I do? So you can have both accrual and cash accounting. So there are certain businesses for task purposes that have to be accrual. We won't get into this on a tax session, but that's going to be the case if you have inventory, et cetera, et cetera.

So the idea of the accrual basis is to tell you how you're doing operationally, okay? That's why you're trying to match the revenue and the expenses. So to me, if you're doing your KPIs just based on a cash basis, not accrual basis, they're kind of misleading. Now, there can be certain KPIs that would be consistent together, but the idea here is that you're really matching in order for you to understand what's going on in the business.

And that's really what the banks want to see because they want to know what your overall cash flow is for doing that. A lot of times too, if you're on a cash basis of kind of receiving banks do this, they will make you do what's called a 13 week operating cash flow analysis. And then they track that all year long to make sure that you're not sandbagging on some expenses in the process.

So there's a lot of different ways you can get to the same point, but the accrual basis is the best way to analyze a business from a banker's standpoint, and I think from an owner's standpoint, because the timing, think about this. If your timing of revenue isn't consistent and your timing of expenses isn't consistent, what good are your financials year over year? Well, if you're really using your financials as a tool to manage your business, you're going to want to forecast what your revenue is going to be so that you know how to manage your expenses. And the only way to do that is with accrual accounting.

You can't do it because you're going to, with cash accounting, you're going to get a pile of cash. You're not going to know how the work was completed. You're not going to know what you billed for and what you didn't.

The only way to have a budget and to manage your business using a budget and a forecast with projections is by doing accrual accounting, right? How do cash businesses figure out what their forecast is going to be? Well, it's a little more difficult. They kind of do it on a, you know, how much revenue they're going to get in each month, they think from a cash standpoint. So it's kind of like a modified cash accrual if you're really doing projections, because they're looking at it from year to year.

But a lot of that's determined in how much they bill. I mean, if you, let's assume you're in a business where you're dealing with insurance companies because people had a flood in their home or fire or whatever, you know, a lot of times what we've seen is people will bill that at the end of November, December, knowing they're not going to get the income until January or February of next year. So for tax purposes, they have a lower taxable income this year, but they're still going to be getting the revenue.

So to me, that's just a complete mismatch because you had all the expenses of providing those services and then there were revenues in another year. Yeah, no. And it's going to inflate one year and make one year look worse.

And it's going to, unless there's somebody around that has the, I guess you would call it historical knowledge or institutional knowledge to say, Oh no, we can't forecast based on that revenue because we took a lump sum that year. It doesn't, I mean, it's just, it's just not a good way to, there's no way to run a railroad. You can't, you can't, you can't run your business and forecast without spreading the revenue, putting the revenue where it actually came in and when you actually recognized it.

Right. And Dan, you're always talking to business owners about getting themselves prepared for maybe a potential sale or something. Those financials are just not going to be reliable.

So you're never going to get square one without getting them to an accrual basis to really reflect the economic. All right. So this is where I was going to go next.

You read my mind. So talk to me about a business owner that comes to you that's got a significant business and is on a cash basis. Do you have to redo their financials from the last X number of years on an accrual basis so that they have consistent financials? I mean, can that business, how do you do evaluation on a business that has been on a cash basis forever? And you know, I mean, what do you do? Well, you have to go through, you know, the accounts that would be, or would make a difference because some accounts like salary may or may not make a difference unless you paid bonuses after you're in, but there are going to be a lot of expenses that will be very close on cash and accrual.

And a lot of them won't be. So you actually have to go through and then what we would call normalizing adjustments. You would make normalizing adjustments for each of the five years or three years, and then have those financial statements revised, and then make sure you document what those are because the reason you're doing that is you're doing it for in preparation of sale, in preparation of a loan, maybe.

There's probably a different financing source. So it has to have a credibility, you know, to those financials and preparing those and then saying that you took the cash basis and you made the following 15 adjustments on a year by year basis to make it consistent. And remember over a three or five year time period, you know, all businesses run into really good things and sometimes not so good things.

And so you also have to normalize the financial statements to say, on a going forward basis, I have to remove this or I have to add this in, because what happened before is not indicative of what's going on in the future, COVID would be one, you know, if there was a disaster would be one, you know, things of this nature. So doing it, it's a pain, but it can be done and it should be done. Because if you're going to be selling out to a third party, all it's going to do is hurt you because you're understating probably your income and your potential.

And that times your multiple is a big number. All right. So what is involved in switching over if, if I've been in business for two years and my business is starting to do well, and I'm going to go to a bank say in six months and try and get, get a line of credit or get some working capital.

And I know the bank is going to say to me, you need to be on your accounting needs to be done on a cruel basis. What is involved in switching? Is there a better time than another time to switch? Because there may be somebody who's watching us or listening to us today. And they, and they're saying to themselves, my accountant has been telling me to switch to an accrual accounting basis for years.

Now I'm listening to Dave and Harry. I want to do it. What do they do? So I, you know, so again, some of this is industry specifics.

We have to set that aside for a second. So I would say that you're better off generally speaking on an accrual basis, even in most industries, because it gives you more flexibility to plan your taxable income plan with the bank. I think if you go to the bank with cash basis, I think they look at you a little bit narrower than you do with your accrual basis.

And if you tell them, look, you're in the process of fixing these things from prior years, they're going to look at you as being more proactive. And if you're more proactive in your conversations with them, I think it does lens that that communication with your banker is being broader and that you're thinking about things before you come to him and they force it down on you. So I think overall, you know, it's a better way to go.

And again, as we just talked about, it helps out from an operation, you know, analytic standpoint, you know, to do that. And I mean, sometimes too, you know, at year end, there are certain expenses that, you know, you might want to accrue bonuses, you might want to accrue a bunch of other things that on a cash basis wouldn't be there, but you're going to pay them out the next month. So, you know, and again, you've got to separate out financial stakes tax, because sometimes you can be on, have one for tax purposes of cash or one on accrual.

So you got to be careful there based on the rules, but I would say going to a bank, looking at selling your company, compare it with, you know, also the other one, Dave, as people forget about is comparing yourself to competitors, because you know, there are databases you can look at. They're probably all on the accrual basis. So if you're comparing yourself to them and they don't have the accrual, you know, financials, then you're doing yourself a disservice.

All right. So which industries does it make sense to stay on a cash accounting basis? You know, sometimes professional service firms will do that, stay on a cash basis, because sometimes they have, you know, sometimes collectability issues. I would say sometimes in some smaller type real estate funds, they might want to be on a cash basis, but I don't, you know, we've seen it done, but we've seen more on the accrual basis because it gives you a lot more flexibility.

So it's, it's fairly, you know, I would say limited in application. And sometimes people think they're going to, you know, eventually, you know, I can plan my taxes better on a cash basis. The answer to that is yes and no.

And, you know, if you come in and you start accruing some expenses that you forgot about, you should have had a cash based service come in and say you would inadvertently change to accrual. You know, that's a fight with them, but, you know, whatever it is. The other thing too, is on a cash basis, if you go from cash to accrual for task purposes, the Internal Revenue Service is usually more accepting of that than they are from you going from accrual to cash.

From accrual to cash, who does that? From accrual to cash. I just decided I'm taking all the money now. You know, you know, Dave, nothing surprises people anymore.

People try to get it. I, listen, I've seen a lot. I haven't seen that.

I'm just, I'm just going to take all the money without accruing anything. All right. So if somebody's starting a business, let's say you're, so you start a business, Harry, right? And what do you do? You, you, you set up a spreadsheet to track your expenses, right? So you want to start a business and you want to do it right.

You're getting a, you're getting a loan from your uncle Joe to start the business. How do you start a business on an accrual basis? You, you have to get an accountant. You have to, you have to set up the books the right way and you have to be able to create a chart of accounts and like all of that has to be set up and you have to have like what you guess at projections for the year, right? Oh yeah.

I mean, that's what all startups are, right? You're guessing at where are you going to be? You're taking in income. I mean, a lot of startups will be on cash basis for one or two years, maybe, and then switch over because again, as they want to bring in money other than uncle Joe's money, people want to know, you know, what's going on there. And it's like a, you know, it's kind of like a lot of things when you're a startup, we've talked about this in other shows, you know, for the first couple of years, you want to be an LLC.

So the flow through losses come to you. And then when, once you get to the next level, then you, then you elect to be a qualified small business company, because then you can take advantage of the special, you know, nuances of qualified small business. So you can't just categorically say all things, all time, got to look at each situation.

And so the startup phase, you're probably better off doing, as I just mentioned, but as you get to the next level, you know, cruel basis is the only, to me, the truly only legitimate way to compare yourself to other businesses. Otherwise you're just shooting in the dark and that's just not a good situation. And you brought something up there that I know people are thinking right now.

So there's no, you can be on an accrual basis and be an LLC. You can be on an accrual basis and be a C Corp. You can be on a cash basis and be an LLC and be a C Corp.

There's no, there's no rhyme or reason to the entity selection and the type of accounting. It's just a good business practice to move to accrual. Right, right.

And just think of LLC, you know, you can be an LLC and taxed as a partnership. You can be an LLC taxed as a C Corp. You can be an LLC taxed as a S Corp.

You know, they're, so you can't do that. So you got to be careful. That's why we always ask people, so you're an LLC.

And I said, well, well, yeah, so what, you know, tell me the next step, you know, how are you actually operating? And you also said something there that I think really makes it clear for the people who are with us. And that is, okay, so if you don't have losses anymore, you're starting to make money. That's when you look at your entity structure and that's when you really got to get your books in order, because once you start to make money and you're no longer passing through those losses, everyone is going to come with their handout for their share of the money that you're making.

So you want to make sure that you're able to project what that's going to look like into the future. And that's where accrual accounting comes in. Yeah.

And so let me give you a simple example. So let's assume you had a startup and let's assume you had other income other than your startup, you know, to fund your living and family and everything else. So those losses, if you're in the highest tax bracket for federal purposes, you're going to get a write-off of that at 37% more than likely.

So what you can do is that 37% that you have saved in taxes, you then have more cash to put back in the business. So when you actually start making profits though, and you say, okay, I want to be a C-corp now because I want to qualify for the qualified small business, you know, a C-corp's only pay 21% federal income taxes today. So why would, why would I want to be a LLC and pay in 37% tax? That's 16% differential is huge from keeping working capital in the business.

That's less investors, less banking I have to have and things of this nature. So, you know, it's not rocket science stuff. It's just applying good business and task principles.

And if you do that at the beginning, it's, it's usually, you know, a home run. All right. So somebody comes to you and they say, Hey, we're going to switch.

We're going to go from cash to accrual accounting. How, you know, is it, is it like compare it to root canal or colonoscopy? How painful is that? How tough, how tough is this going to be? I won't say it was a root canal, but it might be a cap on your root. So it's not, it's not the end of the world.

And they bring you all of their past financials. They bring, they bring you their bank statements that I'm sure you sit down and interview them with where the business is going and who they pay and how they recognize revenue when it comes in. Hey, give us an overview of what the process of switching over is, because there are people out there who probably know they should switch, but they're afraid of the process, right? So what's the process look like? Well, the process is a little bit like what you talked about.

First of all, you gotta look at the historical stuff. Hopefully the same people who were around from several years before to give you the right perspective, just not a made up perspective. And then, as you said, you know, you got to look at, you know, contracts and how they're recognizing revenue.

And remember over a five or six year time period, the business probably has changed about how they're dealing with their customers, what their contracts look like and everything else. You want to make sure that you don't double dip or you miss something in that process, and then you start pulling together the analytics and then you got to compare it to like what the owner feels that they feel they always need. And they base everything on what they do late, let's say in a 40% margin.

Then you can go back and say, okay, we redid these financials. If we did all this, does this make sense to you? How the business was being run at that point in time? Cause it has to pass the litmus test too, to make sure something wasn't missed. So, and then you have to, you know, get rid of a lot of, if you have related party transactions or at least disclose those.

Um, so it's, it's a, it's a process. It's not, it's not all that easy, but it can be done and should be done. If you want to take your business to the next level.

And if, if they have all of the documentation, let's say they have a really good in-house bookkeeper, how long does the process take? Does it take a month? Is it three months? How long does it take to convert over? I'd say it's probably four to five weeks per year that you've got to go back. Oh, so if it's years, five years, it's, it's a, it takes time. Cause remember these people also have their day-to-day jobs, you know, about making sure that this is a speed run.

So it does take a lot of effort. You'd like to condense it. So you get the momentum going.

So you don't do one year, stop, go back three months later, do the other. Uh, cause that just, you know, it's like anything else. Time kills all things.

So you want to do it that way. And that way too, you get a little bit of efficiency in a process, you know, as you're doing it. Is there a better time of year? Obviously you're not going to do it.

I would imagine you're probably not going to do it between January and April when it's tax season. Is there a better time of year to do it than others? Yeah. I mean, we have, we have a pretty robust, we call it cast team, you know, client accounting services.

So they can do it, you know, anytime during the year, but obviously tax time's a little more strenuous on everyone. So you'd like to do a post four or 15 if you can, but if you need to do it beforehand, we have a big enough team that we can handle that. All right.

So if you have heard something today that has triggered you to want to get up and go into the big leagues and move to accrual accounting, you need to call Harry Sandrowski. You can reach out to him at 866-717-1607, 866-717-1607. Sandrowski Corporate Advisors is based in Bloomfield Hills, Michigan, but they can work anywhere in the country because they're a division of prosperity partners.

And by the way, this is not all they do. They do a whole host. They offer a whole host of services.

And Harry's real specialty is helping you mitigate your tax exposure. What we're talking about today. It seems pretty basic, but believe it or not, this is one of the opening conversations I have with business owners from the point where we start working with them, when I say to them, tell me about your financials, who's managing them and how do you do your accounting? And they say, what do you mean? This conversation always comes up and it always involves how they forecast, how they budget, and whether they're on cash or accrual accounting.

Reach out to Harry today. He'll help you understand this better. 866-717-1607.

Harry, thank you for shedding some light on this. And we appreciate you being here with us every Monday. Hi, Dave.

This was fun today. It's kind of a subject matters that are not always for what people want to talk about, but it's kind of fun. You know, I talk about accrual accounting every day.

I don't know about you, but in fact, the reason we're doing this show is because this came up two days ago and I was like, I need to point to something where people can read or watch or look at it before we have the conversation about accrual accounting. So Harry, thank you for providing that here today. All right, folks, that'll do it for this episode of the inside BS show.

If you've got a friend who's on cash accounting, send them the show so they know what they need to do. Reach out to Sandrowski Corporate Advisors. Harry will help you at 866-717-1607.

I'm Dave Lorenzo. This is the inside BS show. We'll be back here again tomorrow at 6am with another show.

Until then, here's hoping you make a great living and live a great life.