This series is primarily for entrepreneurs, especially for people who are just starting up or thinking of starting a company. I know that there are various resources available for financial accounting. Unfortunately, most such resources assume that the reader is going to become an analyst or an accountant. There is some fundamental difference between how an analyst looks at finances and an entrepreneur looks at finances.
The difference lies in the goals of an analyst, an accountant and an entrepreneur. An analyst’s goal is primarily to value the business so that he can take advantage of any wrong valuation by the market, an accountant's goal is to report the finances in a way that follows the prevailing regulations but an entrepreneur's goal is to run, grow and often, simply survive the business. Looking at the finances from the lenses of an analyst or an accountant can lead to decisions detrimental to business.
The primary reason can be described as an adage:
“Business runs on a cash basis, reported on accrual basis”
Now, we will understand the differences between cash and accrual basis accounting. The fundamental difference is how revenue and expenses are recorded.
Consider that you produce small appliances and sell to resellers. Now, on March 28th 2019 you invoiced items worth Rs. 1 crore to a large reseller. You provide a 15 day credit period to the reseller. According to this, you are expected to get the money from the reseller on 11-12th or April 2019.
In which year will you recognise this Rs. 1 crore revenue? In the financial year 2018-19 or 2019-20?
Note: In India, the financial years runs from 1st April to 31st March of next year.
According to the accrual basis accounting which is used for reporting, you will recognise the revenue the day invoice is created i.e. in the financial year 2018-19. But, the reality is that you did not receive the cash yet. There are many things which can happen after invoicing and before the cash payment. Things that can limit the amount of cash received or delay in the payment. For large corporations, who enjoy significant negotiating power over the resellers, this is not a problem but small companies especially startups may have a hard time collecting payments. The point is that for small companies there is some amount of uncertainty associated with the accounts receivable which accrual basis accounting fail to consider.
Now, in a cash basis accounting, revenue is recognised when cash is received. In the above-mentioned example, the revenue of Rs. 1 crore will be recognised when cash is received which is (hopefully) in the financial year 2019-20.
You can see that how an accrual basis revenue recognition distorts the picture for an entrepreneur. The reality is that you cannot pay your bills with the accounts receivable.
Consider another situation. You also dealt with a smaller reseller and negotiated an advance payment of 50% before the delivery of the items. Consider you got the advance on 28th March 2019 but delivered the items on 15th April 2019.
As per accrual accounting, the 50% advance will be recorded as unearned revenue and will appear on the balance sheet of the company as a liability.
But, the reality is that you can use that money for procuring raw materials and paying for labour to produce the products.
Consider that the facility you use to produce the appliances is rented. The owner of the property demanded one year’s rent in advance. So, you have to make payment for the next financial year on March 31st of this financial year.
As per the accrual accounting rules, you recognise the expenses when you actually consume the goods or services. So, the payment made on the 31st March 2019 is recorded as prepaid expenses and no expenses are registered in the profit and loss statement.
On a cash basis, you have already paid the amount in the financial year 2018-19 and expense are registered accordingly. This is also the business reality. You are out of that money which could have been used to pay salaries or buy tools.
Consider now, you have a good relationship with the property owner and he allowed you to pay rent quarterly after you use the property. For example, rent for April- May-June 2019 is payable on 30th June. What is your rent expenses as of 30th April 2019?
As per accrual basis accounting, you have to register rent for one month in the financial year 2019-20 although you have not departed with any cash. This will appear on the balance sheet as accounts payable which is a liability.
As per cash basis accounting, there is no expense yet because there is no cash outflow.
Note: Even though I am emphasising that for an entrepreneur tracking the cash is more important, balances in accounts payable and unearned revenue are important too. These show kinds of contractual liabilities which the entrepreneur should always be aware of.
The point of this post is not to imply that accrual basis accounting is not important but to make the entrepreneurs realise that tracking the cash is vital for your business.
If you are a startup founder and designing the business processes, you must consider the cash-flow implications. A highly profitable business (on the basis of accrual accounting) may run out of cash especially when it is growing fast.