Methods To Run A Healthy Business
There are a number of variables to consider when building your busines’s recordkeeping system. As the owner of your busienss, you need to make sure your system is both adequate and appropriate for you and your business.
- An adequate recordkeeping system will substantiate your income and deductions reported to the IRS and other taxing agencies.
- An appropriate recordkeeping system helps you manage financial health.
Below I’ve described two options to consider when building an appropriate recordkeeping system. In short, an appropriate recordkeeping system helps you manage the cash inflows and outflows of your business. If you have not already read part 1: only the basics, then I encourage you to read it first.
An Appropriate Recordkeeping System: Information To Guide Decision Making
Appropriate recordkeeping goes beyond ‘what is required’ and into the world of ‘what is useful’. When built and managed correctly, an appropraite recordkeeping system will allow you to run a financially healthy business.
Cash basis recordkeeping
The most basic way to record income and expenses is on the cash basis. In this method, income is recorded when received and expenses are recorded when paid. The ‘triggering event’ to record an item is when it clears your checking or credit card statement. Compared to the accrual basis, see below, little work is required to capture income and expenses using this method. Plus most businesses use this method for income taxes. When it comes to financial management, this method gives the owner a ‘high-level’ understanding of their net income (profit) and satisfies the minimum tax reporting requirements discussed in part I.
Business owners who sell less than $100,000 in goods or services can generally get away with recording items on the cash basis. These busineses experience low volitility in month-by-month activities and owners are often in close contact with their customers and vendors. Should something come up, such as a cash-pinch, the owner can call his small handfull of clients and request payment or easily cancel simple cash-outs such as subscriptions.
As businesses grow beyond the $100,000 annual revenue mark: month-by-month activities become less predictable, seasonal cash in-flows evolve, subcontractors and employees are hired to satisfy the increasing sale volumes, non-cancellable professional service agreements are entered into, and customers often request payment terms. With business growth comes moving parts and bigger demands on cash. It can be difficult to keep tabs on everything, especailly cash-ins and cash-outs on any given day.
Pros to the cash basis:
- Generally satisfies income tax reporting requirements.
Cons to the cash basis:
- Does not capture when money is owed (receivables or payables).
- Items can easily ‘slip-through-the-cracks’.
- It is harder to predict cash balances, often resulting in costly overdraft fees.
Accrual basis recordkeeping – rights to collect and obligaations to pay – foundation for cash management
The accrual basis satisfiles most needs of any business. In the accrual method, income is recorded when earned and expenses are recorded when incurred.
Income is earned when you sell a good or perform a service. Revenue is recorded when you send your customer an invoice. This event creates a receivable and is your claim to receive money from your customer. When the customer makes a payment, say via a check, the check is deposited to your bank account and the receivable is eliminated.
The same holds true for expenses, just in the opposite direction. You are obligated to pay your vendors when the vendor sends you a bill and the obligation is eliminated when you pay the bill.
Using the accural method you can see how much customers owe you at a point-in-time. In a pinch, you can generate an accounts receivable aging report and make a few targeted calls to get cash in-hand. No scrambling to get your ducks in a row and drum-up cash. On the flip-side, recording expenses on the accrual basis gives you visibility into future cash-outs and the opportunity to leverage payment discounts. This could save you lots of dollars when cash is flush.
Much more detail can be captured when using the accrual basis. In QuickBooks Online, there is an ability to capture and report activities by class. Owners will use classes to evaluate the profitability of different products, service lines, activity types, or locations. When business-wide profit margins show a negative trend, you as the owner can generate a profit and loss by class report to see which product, service, activity, or location, is struggling and take corrective actions before things get too costly.
Pros to the accrual basis:
- Better represents business health.
- Better visibility into operations.
- The ability to forecast cash-in, cash-out, and future cash balances.
- The ability to make better, informed decisions.
Cons to the accrual basis:
- More time or money to record items.
What is best for you?
You’re going to have to weigh the pros and cons to decide which option is best for you. Most businesses record items on the accrual basis but report taxable net income on the cash basis. Doing so satisfies the adequate recordkeeping requirements discussed in part I and is apporpriate for owners to run a financially healthy business.
If you’re still uncertain, you can read more and see examples on our bookkeeping page. We can also do a process & systems assessment to help you make your decision. If you’d like help deciding, or would like someone to take-over bookeeping for you, then send us a message and we’ll connect with you soon.