This may be a surprise to hear, but there are several different—yet appropriate—basis of accounting, whether it is on cash or accrual basis for small and midsize businesses. There are two primary drivers of how to determine your accounting method:
- A regulatory need, e.g., the SEC or IRS
- A consideration of the audience (or users) of the data or overall financial statements, which could vary in complexity from a sole owner to a board of directors, or a complex table of investors and/or creditors
What also might be surprising to hear is that there are often different basis or ways of accounting for different circumstances or users of that accounting. A more complex regulator or financial statement user (for example, the SEC or third-party lender) would most likely require financials that are reported under the framework of GAAP. This accounting framework is the comprehensive, principle-based set of accounting standards in the United States. On the other side of the spectrum, some small business owners derive meaning from their cash-basis financials. For many of these small businesses, cash-basis reporting also is appropriate for income tax filings as well. So, one thing is for sure … when it comes to accounting methods, not one method fits all.
What to consider regarding different reporting and basis of accounting
Small and midsize business owners should know who their regulators are and what basis of accounting is required to meet those required standards. However, and perhaps more important to the success and growth of your business, is to know and understand what information is being reported in your financial statements. In other words, who is your audience, and what insight does your accounting provide to that audience?
Before determining what basis of accounting is best for that audience, you need to determine the key drivers of success (and risks) in your business. For example, is the monitoring of the gross profit percentage critical—or what about the overall cash cycle? And how is this different from when you incur expenses and record revenues? There is no doubt that GAAP accounting is the gold standard for financial statements, but strict GAAP compliance may be burdensome if management quickly wants to measure profits by customer, job, or employee. What if management also desires to benchmark KPIs against its industry? Unless you are comfortable with the risk of comparing apples to oranges, you had better understand and use the basis of accounting consistent with your industry.
So where do you start? Accounting is all about accuracy and timing. As such, even for businesses that don’t require audited GAAP financials, an accrual-basis of accounting method is critical to appropriately record revenues and expenses in the appropriate period.
What is the “revenue cycle” and what do small businesses need to know about it?
The revenue cycle is essentially the system of processes a small or midsize business has in place to initiate and complete the revenue process. This basically ranges from taking a sales order request to delivery of product or service, billing of the account, and the ultimate collection of payment.
Along with this process are two critical accounting functions:
- The recording of revenue in the appropriate period, e.g., the day, week, month it is “earned”
- The billing and ultimate collection of payment
The revenue cycle will vary greatly in time and complexity based on the type of product or service in your industry. For example, a manufacturer will have a more complex and longer revenue cycle than a restaurant, yet the first two lines of these industries’ income statements could look very similar, i.e., gross revenue and costs of goods sold. Now, compare this to a nonprofit that receives a donation via credit card. This results in very different reporting on the financials, yet the revenue cycle and timing might be extremely similar to a quick-service restaurant.
Big picture, the overall guidance for small and midsize businesses is to understand your revenue cycle, implement a system to timely and accurately capture the key data inputs, and be consistent with your method of accounting.
What are other practical suggestions for small and midsize businesses?
The speed of business is only getting faster, thereby shortening the time window to make wise decisions. To counteract this, small and midsize businesses may want to do the following:
- Assess your revenue cycle to specifically identify manual processes and outdated technologies that slow down reporting
- Define or refresh the key drivers of growth and success in your business and industry
- Mitigate your regulatory and income tax risk by engaging an experienced professional to assist you with meeting those burdens
- Be sure to inquire about different, yet appropriate, accounting methods that could be helpful to your company
Upon completion of this assessment, invest in and implement a system of technology, processes, and people with the goals of:
- Automating as many of the accounting processes and reporting as possible while still providing accurate reporting in accordance with your company’s accounting methods
- Capturing the key performance indicators—as real-time as possible—to share with management and other decision makers
- It is critical that this data is either embedded within or connected to your accounting system
- And lastly, working efficiently and effectively with your trusted advisor to reduce regulatory risk and defer tax outflows
This article is a selected piece from By the Books: FORVIS' Complete Guide to Small Business Accounting & Finance, which we are excited to release in April 2023. Subscribe to our Small Business list to get future updates and articles and be the first to receive the full guide.