accounting excels in tracking the actual cash available.
Chapter 4: Digging into Accounting Basics
45
✓
Accrual accounting: Expenses and revenue are matched, providing a company with a better idea of how much it’s spending to operate each month and how much profit it’s making. Expenses are recorded (or accrued) in the month incurred, even if the cash isn’t paid out until the next month. Revenues are recorded in the month the project is completed or the product is shipped, even if the company hasn’t yet received the cash from the customer.
The way a company records payment of payroll taxes, for example, differs with these two methods. In accrual accounting, each month the company sets aside the amount it expects to pay toward its quarterly tax bills for employee taxes using an accrual (paper transaction in which no money changes hands). The entry goes into a tax liability account (an account for tracking tax payments that have been made or must still be made). If the company incurs $1,000 of tax liabilities in March, that amount is entered in the tax liability account even if the firm hasn’t yet paid out the cash. That way, the expense is matched to the month in which it’s incurred.
In cash accounting, the company doesn’t record the liability until it actually pays the government the cash. Although it incurs tax expenses each month, the company using cash accounting shows a higher profit during two months every quarter and possibly even shows a loss in the third month when the taxes are paid.
To see how these two methods can result in totally different financial statements, imagine that a carpenter contracts a job with a total cost to the customer of $2,000. The carpenter’s expected expenses for the supplies, labor, and other necessities are $1,200, so his expected profit is $800. He contracts the work on December 23, 2008, and completes the job on December 31, 2008, but he isn’t paid until January 3, 2009. The contractor takes no cash upfront and instead agrees to be paid in full at completion.
If he uses the cash-basis accounting method, because no cash changes hands, he doesn’t have to report any revenues from this transaction in 2008.
But say he lays out the cash for his expenses in 2008. In this case, his bottom line is $1,200 less with no revenue to offset it, and his net profit (the amount of money his company earns, minus expenses) for the business in 2008 is lower. This scenario may not necessarily be a bad thing if he’s trying to reduce his tax hit for 2008.
If you’re a small-business owner looking to manage your tax bill and you use cash-basis accounting, you can ask vendors to hold off payments until the beginning of the next year to reduce your net income, thereby lowering your tax payments for the year.
46 Part I: Getting Down to Financial Reporting Basics Incentives and the bottom line
To improve the bottom line, many companies
salesperson hadn’t met quota or was compet-
offer their salespeople different kinds of incen-
ing to win a sales contest.
tives at the end of a month, quarter, or year. The
If a company gets really aggressive with its
more the salespeople sell, the more income the
end-of-period revenue-booking practices, it can
company records, allowing it to report stronger
inflate its actual earnings, especially if sales-
earnings for that period.
people allow customers to sign orders with the
You’ve probably seen this concept put into promise that they can cancel their orders early action if you’ve ever made a major pur-in the next month or accounting period. Some
chase, such as a car, at the end of the month.
companies have gotten into trouble by record-
You probably found that you could be much ing sales on products that weren’t yet shipped more aggressive with your negotiations if the
in order to make a quarterly or monthly goal.
If the same carpenter uses accrual accounting, his bottom line is different. In this case, he books his
Chapter 4: Digging into Accounting Basics
45
✓
Accrual accounting: Expenses and revenue are matched, providing a company with a better idea of how much it’s spending to operate each month and how much profit it’s making. Expenses are recorded (or accrued) in the month incurred, even if the cash isn’t paid out until the next month. Revenues are recorded in the month the project is completed or the product is shipped, even if the company hasn’t yet received the cash from the customer.
The way a company records payment of payroll taxes, for example, differs with these two methods. In accrual accounting, each month the company sets aside the amount it expects to pay toward its quarterly tax bills for employee taxes using an accrual (paper transaction in which no money changes hands). The entry goes into a tax liability account (an account for tracking tax payments that have been made or must still be made). If the company incurs $1,000 of tax liabilities in March, that amount is entered in the tax liability account even if the firm hasn’t yet paid out the cash. That way, the expense is matched to the month in which it’s incurred.
In cash accounting, the company doesn’t record the liability until it actually pays the government the cash. Although it incurs tax expenses each month, the company using cash accounting shows a higher profit during two months every quarter and possibly even shows a loss in the third month when the taxes are paid.
To see how these two methods can result in totally different financial statements, imagine that a carpenter contracts a job with a total cost to the customer of $2,000. The carpenter’s expected expenses for the supplies, labor, and other necessities are $1,200, so his expected profit is $800. He contracts the work on December 23, 2008, and completes the job on December 31, 2008, but he isn’t paid until January 3, 2009. The contractor takes no cash upfront and instead agrees to be paid in full at completion.
If he uses the cash-basis accounting method, because no cash changes hands, he doesn’t have to report any revenues from this transaction in 2008.
But say he lays out the cash for his expenses in 2008. In this case, his bottom line is $1,200 less with no revenue to offset it, and his net profit (the amount of money his company earns, minus expenses) for the business in 2008 is lower. This scenario may not necessarily be a bad thing if he’s trying to reduce his tax hit for 2008.
If you’re a small-business owner looking to manage your tax bill and you use cash-basis accounting, you can ask vendors to hold off payments until the beginning of the next year to reduce your net income, thereby lowering your tax payments for the year.
46 Part I: Getting Down to Financial Reporting Basics Incentives and the bottom line
To improve the bottom line, many companies
salesperson hadn’t met quota or was compet-
offer their salespeople different kinds of incen-
ing to win a sales contest.
tives at the end of a month, quarter, or year. The
If a company gets really aggressive with its
more the salespeople sell, the more income the
end-of-period revenue-booking practices, it can
company records, allowing it to report stronger
inflate its actual earnings, especially if sales-
earnings for that period.
people allow customers to sign orders with the
You’ve probably seen this concept put into promise that they can cancel their orders early action if you’ve ever made a major pur-in the next month or accounting period. Some
chase, such as a car, at the end of the month.
companies have gotten into trouble by record-
You probably found that you could be much ing sales on products that weren’t yet shipped more aggressive with your negotiations if the
in order to make a quarterly or monthly goal.
If the same carpenter uses accrual accounting, his bottom line is different. In this case, he books his
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