Converting cash accounting to accrual
The last subject in this section of the chapter briefly discusses the underlying factors of the statement of cash flows (see Chapter 11). While concentrating on the accrual method of accounting, your financial accounting course talks about the cash method as well. So, knowing the nuts and bolts of converting cash to accrual revenue and payments will make both the theory and preparation of the statement of cash flows more understandable.
Small business owners will find this helpful as well. You may have just blundered into using a method of accounting without realizing there are two or three if you count the tax method. Or maybe you have a bookkeeper or accountant running your numbers, and they have made the decision for you.
Before I present my handy guide to converting cash to accrual, you may find it helpful to check out Chapter 6, where I expand on cash, accrual, and tax.
Following is a rundown of the cash and accrual methods, with a brief explanation of how the Internal Revenue Code can affect both.
Cash method: Revenue is recorded when it is received, and expenses are recorded when they are paid. The effects of accounts receivable and accounts payable are eliminated.
Accrual method: The opposite of cash, you record all revenue when it is earned and realizable. Expenses are recorded when they are incurred. Accounts receivable and accounts payable are definitely a part of this equation! Costs and expenses are not the same. Financial accounting uses the matching principle (see Chapter 12). The cost of buying something like inventory does not record on the income statement until it can be matched — that is, used to create revenue. Chapter 13 give you a good walkabout on the matching principle, too.
Tax: I’m adding this in for you small business owners so that you know what’s going on when your bookkeeper or accountant starts blathering on about GAAP versus tax. In the United States., tax returns are filed using the constraints of Internal Revenue Code.A fantastic example of this at work is entertainment expense. Generally, the cost of taking clients out to dinner is expensed 100 percent, but Internal Revenue Code allows only a 50 percent deduction. That means for a meal costing $75, you are able to deduct only $37.50 on your business tax return.
Ready to go? Figure 3-5 is my handy cash to accrual conversion guide.
FIGURE 3-5: Cash to accrual cheat sheet
Making Figure 3-5 come alive with numbers, in May Tom & Cindy received $5,000 in cash from customers. On May 1, accounts receivable was $1,245. On May 31 accounts receivable was $980. May revenue earned is $4,735 ($5,000 –$1,245 + 980).
Improving cash flow
Earlier in this chapter in the “Managing Cash” section, I emphasize the need to keep a handle on cash because having inadequate cash flow is the No. 1 reason why new businesses fail. You walked through Izzie Tees and Jeans Cash Budget and found that Izzie had a $10,872 cash shortfall as of the end of February.
Some quick suggestions were for Izzie to put off unnecessary purchases and try to extend terms for purchases she had made on account. On account simply means the vendor has shipped inventory to Izzie with a promise from Izzie to pay for it within a certain time frame. I want to delve into the topic of short-term debt (see Chapter 8).
It’s quite common in the business world to occasionally have a situation where you have to make payroll, and there just isn’t enough money in the business checking account to cover it. This sounds bad at face value, but there are some less than dire reasons for this to happen.
Accounts receivable is a biggie. Maybe you have a substantial customer that buys on credit. Based on your business relationship going back years, you know they will honor their commitment to send payment in the next 15 days. The cash implications are not a big deal.
Or the company may be in the business of manufacturing a seasonal item, such as patio furniture. Past performance has shown that 75 percent of sales take place in April through August. However, it is more efficient to manufacture the patio furniture year-round.
To finance the increase in patio furniture inventory, the company decides to take on short-term debt. The two most prevalent types of short-term debt (well, besides a loan from Mom!) are working capital loans and revolving lines of credit.
Working capital loans: This type of loan is made with the expectation that it will be paid back in the short term from sales and collections of accounts receivable. Short term means within 12 months. My students are usually surprised by the effect that working capital loans have on ratio analysis (see Chapter 14). Because cash and working capital loans are both current there is no effect on the current ratio. The addition to cash, a current asset, is cancelled out by the increase in working capital loans, which is a current liability.
Revolving line of credit: This source of cash is a maximum amount set by the lending institution, which the business uses at its discretion. Based on the terms, there is usually a requirement to make periodic payments once the funds are accessed.
Finally, keep in mind that there is no free lunch! Interest expense is a cost associated with the use of short-term debt —unless of course, the company lucks into an interest-free loan. Even those loans have a cost as the origination fee is generally anywhere from 3 to 5 percent of the loan amount.
Chapter 4
Acronym Alert! Setting the Standards for Financial Accounting
IN THIS CHAPTER
If you’re not into following rules, financial accounting may not be the best career choice for you. You may want to consider the performing arts instead, or perhaps politics.
But if you’re the kind of person who thrives in a structured work environment, you’ve come to the right profession. The work of an accountant is carefully guided by standards, rules, and regulations that I introduce in this chapter.
After a whirlwind tour through the history of accounting, I present an overview of the financial accounting code of professional conduct, which is set by the American Institute of Certified