Financial statements are critical to monitoring your business’s financial health. In addition to helping management make informed business decisions, year-end and interim financial statements may be required by lenders, investors, and franchisors. Here’s an overview of two common accounting methods (cash-basis & accrual-basis), along with the pros and cons of each method.

1. Cash-basis

Under the cash-basis method of accounting, transactions are recorded when cash changes hands. That means revenue is recognized when payment is received, and business expenses are recorded when they’re paid. This method is used mainly by small businesses and sole proprietors because it’s easy to understand. It also may provide tax-planning opportunities for certain entities.

The IRS allows certain small businesses to use cash accounting. Eligible businesses must have average annual gross receipts for the three prior tax years equal to or less than an inflation-adjusted threshold of $25 million. The inflation-adjusted threshold is $30 million for the 2024 tax year (up from $29 million for 2023). Businesses that use this method have some flexibility to control the timing of income and deductions for income tax purposes. However, this method can’t be used by larger, more complex businesses for federal income tax purposes.

Beware: There are some disadvantages to cash-basis accounting. First, it doesn’t necessarily match revenue earned with the expenses incurred in the accounting period. So cash-basis businesses may have a hard time evaluating how they’ve performed over time or against competitors. Management also may not know how much money the company needs to collect from customers (accounts receivable) or pay to suppliers and vendors (accounts payable and accrued expenses).

2. Accrual-basis

The accrual-basis method of accounting is required by U.S. Generally Accepted Accounting Principles (GAAP). So, most mid-sized and large businesses in the United States use accrual accounting. Under this method, businesses record revenue when it’s earned and expenses when they’re incurred, regardless of when cash changes hands. It’s based on the matching principle, where revenue and the related business expenses are recorded in the same accounting period. This principle may help reduce significant fluctuations in profitability over time.

Revenue that’s earned but not yet received appears on the balance sheet, usually as accounts receivable. And expenses incurred but not yet paid are reported on the balance sheet, typically as accounts payable or accrued liabilities. Accrual accounting also may require some companies to report complex-sounding line items, such as prepaid assets, work-in-progress inventory and contingent liabilities.

Although this method is more complicated than cash accounting, accrual accounting provides a more accurate, real-time view of a company’s financial results. So it’s generally preferred by stakeholders who review your business’s financial statements. Accrual accounting also facilitates strategic decision-making and benchmarking results from period to period — or against competitors that use the accrual method.

Additionally, businesses that use accrual accounting may enjoy a few tax benefits. For example, they can defer income on certain advance payments and deduct year-end bonuses that are paid within the first 2½ months of the following tax year. However, there’s also a tax-related downside: Accrual-basis businesses may report taxable income before they receive cash payments from customers, which can create hardships for businesses without enough cash reserves to pay their tax obligations.

Choosing the right method

To recap, not every business is able to use cash-basis accounting — and it has some significant downsides. But if your business has the flexibility to use it, you might want to discuss the pros and cons. Contact us for more information.

The top line of an income statement for a for-profit business is revenue (or sales). Reporting this line item correctly is critical to producing accurate financial statements. Under U.S. Generally Accepted Accounting Principles (GAAP), revenue is recognized when it’s earned. With accrual-basis accounting, that typically happens when goods or services are delivered to the customer, not necessarily when cash is collected from the customer.

If revenue is incorrectly stated, it can affect how stakeholders, including investors and lenders, view your company. Inaccurate revenue reporting also may call into question the accuracy and integrity of every other line item on your income statement, as well as amounts reported for accounts receivable and inventory. So, auditing revenue is an essential component of a financial statement audit.

Audit standards

Under GAAP, you typically must follow Accounting Standards Codification (ASC) Topic 606, Revenue from Contracts with Customers. This standard went into effect in 2018 for calendar-year public companies and 2020 for calendar-year private entities. It requires more detailed, comprehensive disclosures than previous standards.
Under ASC 606, there are five steps to determine the amount and timing of revenue recognition:

1. Identify the contract with a customer.
2. Identify the performance obligations in the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the performance obligations.
5. Recognize revenue when the entity satisfies the performance obligation.

When auditing revenue, auditors will analyze your company’s processes, including the underlying technology and internal controls, to ensure compliance with the rules. The goals are to ensure that your process properly records every customer obligation accurately and that revenue is reported in the correct accounting period.

Audit procedures

During fieldwork, auditors will scrutinize internal controls related to every phase of a customer contract, the appropriate segregation of duties, and the accounting processes governing the booking of revenue in the appropriate periods. They’ll also select a sample of individual customer transactions for in-depth testing. This may include reviewing contracts and change orders, inventory records, labor reports, and invoices to ensure they support the revenue amounts recorded in the general ledger. In addition to helping validate your revenue recognition process, testing individual transactions can uncover errors, omissions, and fraud.

Auditors will also analyze financial metrics to root out possible anomalies that require additional inquiry and testing. For example, they might compute gross margin (gross profit divided by revenue) and accounts receivable turnover (revenue divided by accounts receivable) over time to evaluate whether those ratios have remained stable. They might compare your company’s ratios to industry benchmarks, too, especially if demand or costs have changed from prior periods.

Eyes on the top line

Stakeholders — including investors, lenders, suppliers, customers, employees, and regulatory agencies — use the information included in financial statements for many purposes. If your revenue recognition process is flawed, it tends to trickle down to other financial statement line items, compromising the integrity of your financial statements. So, it’s important to get it right. Contact us to discuss audit procedures for revenue and ways to improve your revenue recognition process.

In today’s uncertain marketplace, many businesses are stashing operating cash in their bank accounts, even though they might not have imminent plans to deploy their reserves. However, excessive “rainy day” funds could be an inefficient use of capital. Here’s a systematic approach to help estimate reasonable cash reserves and maximize your company’s return on long-term financial positions.

What’s the harm in stockpiling cash?

An extra cushion helps your business weather downturns or fund unexpected repairs and maintenance. But cash has a carrying cost — the difference between the return companies earn on their cash and the price they pay to obtain cash.

For instance, checking accounts often earn no (or very little) interest, and many savings accounts generate returns below 2%. If a company has cash reserves while simultaneously carrying debt on its balance sheet, such as equipment loans, mortgages and credit lines, it will pay higher interest rates on loans than it’s earning from the bank accounts. This spread represents the carrying cost of cash.

What’s the optimal amount of cash to keep in reserve?

Unfortunately, there’s no magic current ratio (current assets divided by current liabilities) or percentage of assets that’s right for every business. A lender’s liquidity covenants are just an educated guess about what’s reasonable.

However, you can analyze how your company’s liquidity metrics have changed over time and how they compare to industry benchmarks. Substantial increases in liquidity — or ratios well above industry norms — may signal an inefficient deployment of capital.

Prospective financial reports for the next 12 to 18 months can be developed to evaluate whether your company’s cash reserves are too high. For example, a monthly forecasted balance sheet might estimate expected seasonal ebbs and flows in the cash cycle. Or a projection of the worst-case scenario, based on certain what-if assumptions, might be used to establish a company’s optimal cash balance. Forecasts and projections should take into account a business’s future cash flows, including capital expenditures, debt maturities, and working capital requirements.

Formal financial forecasts and projections provide a method for building up healthy cash reserves. This is much better than relying on gut instinct. You also should compare actual performance to your forecasts and projections — and adjust them, if necessary.

What’s the highest and best use of excess cash?

After prospective financial reports and industry benchmarks have been used to determine a company’s optimal cash balance, management needs to find ways to reinvest its cash surplus. For example, you might consider repurposing the surplus to:

• Invest in marketable securities, such as mutual funds or diversified stock-and-bond portfolios,
• Repay debt to lower the carrying cost of cash reserves,
• Repurchase stock, especially when minority shareholders routinely challenge management’s decisions, or
• Acquire a struggling competitor or its assets.

With proper due diligence, these strategies could allow your business to reap a higher return over the long run than leaving funds in a checking or savings account.

We can help

Contact us for help creating formal financial forecasts and projections and evaluating benchmarking data to devise sound cash management strategies. We can guide you toward more efficient use of capital while reserving enough cash on hand to meet your business’s short-term operating needs.

If your business has significant inventory on its balance sheet, it can be costly. The carrying costs of inventory include warehousing, salaries, insurance, taxes, and transportation, as well as depreciation and shrinkage. Plus, tying up working capital in inventory detracts from other strategic investment opportunities.

Reducing these costs can help improve a company’s profits and boost operating cash flow. Here are two alternative inventory management systems to consider.

1. JIT method

Just-in-time (JIT) inventory management involves planning shipments of raw materials to arrive just before they’re required. This saves money in inventory costs by reducing the amount of inventory on hand. It also increases production responsiveness and flexibility. Elements of JIT management include:

Smaller lot sizes. This allows your company to be more flexible and meet changes in market demand. It can also decrease inventory cycle time, lead times, and pipeline inventory. Because lot sizes are smaller, companies that use the JIT method can achieve a consistent workload on the production system.

Tighter set-up times. By reducing set-up times and the associated costs, you can afford to produce smaller lot sizes. Also, if your company is inefficient on machine setups, you’ll likely change products less often.

Flexibility. A flexible workforce can quickly reassign tasks during bottlenecks or unplanned spikes in demand.

Close supplier relationships. Suppliers must provide frequent, on-time deliveries of high-quality materials. So, close ties with them are vital to the JIT system. Long-term relationships with suppliers promote loyalty and improve overall quality.

Regular maintenance schedules. For companies with a high degree of automation, preventive maintenance is critical. Unplanned downtime can be disruptive and costly.

Quality control. JIT systems are designed to control quality at the source, rather than later in the process. For that reason, production workers are responsible for their own work, and if a defective unit is discovered, it’s returned to the area where the defect occurred. This makes employees accountable and empowers them to produce higher-quality products.

2. Accurate response method

Accurate response inventory management systems focus on forecasting, planning, and production. The underlying premise of accurate response focuses on flexible processes and shorter cycle times to better match supply with demand. By speeding up the supply chain process, management can delay decisions regarding raw materials, obtain more market information, and better determine production requirements.

This inventory management method incorporates the following key elements:

Overall performance. Accurate response measures the cost per unit of stockouts and markdowns. Then it factors this information into the overall evaluation of the company’s performance. Let’s say your company can’t meet demand. The lost sales would be factored into the overall costs, which would then justify increasing production to obtain and maintain customers.

Predictable and unpredictable products. Predictable products can be made further in advance to “reserve” capacity during the selling season for unpredictable products. Then your company won’t have to accumulate and pay for large inventories.

For more information

Incorporating JIT and accurate response techniques can dramatically improve your company’s efficiency. Lowering inventory levels cuts operating capital needs and gives you a competitive edge. Reducing the expenditures for warehouses, employees, and equipment produces a stronger balance sheet and income statement and improves cash flow.

Contact us to discuss whether it makes sense to implement these systems at your business.

Financial reporting plays a key role when a business needs funds for continued operations and strategic investment opportunities. Lenders and investors will generally want to review your company’s financial statements before they give it money. Timely, reliable reports can increase the odds that a bank will approve your company’s loan application and equity investors will provide capital.

Relevant financial information

Financial statements are a must-have for any organization. The balance sheet reveals how much its assets and liabilities are worth based on historic costs. The income statement tells investors and lenders how profitably and efficiently the company has performed during the accounting period. The statement of cash flows details sources and uses of cash from operating, investing, and financing activities. This information helps company insiders — as well as lenders and investors — make better-informed business decisions.

Lenders and investors monitor the financial condition of companies in their portfolios on an ongoing basis. They’re particularly focused on industry sectors that are susceptible to market fluctuations, such as real estate, construction, restaurants, and retail. Business owners should be prepared to respond to changes in their stakeholders’ reporting requirements if the economy gets tough or simply changes.

Levels of assurance

While financial statements can be prepared in-house, lenders and investors typically prefer reports that are prepared by outside accounting firms. CPAs offer the following three types of historical financial statements under U.S. Generally Accepted Accounting Principles (GAAP):

1. Compiled statements. These provide no assurance that the financial statements are accurate, complete, and comply with GAAP.
2. Reviewed statements. These provide limited assurance that the financial statements are accurate. Typically, your accountant will review the statements to ensure that obvious errors or misstatements are corrected.
3. Audited statements. These provide reasonable assurance that the statements are free from material misstatement and conform to GAAP. Audits are seen by many as the “gold standard” in financial reporting.

In some cases, compiled financial statements — the option that provides the lowest level of assurance — might suffice. But when a stakeholder decides to manage risk more closely, it could require reviewed or audited statements. As the level of assurance increases, so too can the associated cost to prepare the financial statements. A close partnership between your company’s accounting department and its CPA firm is critical to minimizing the cost and lead time associated with preparing financial statements.

In addition to the types of statements lenders and investors may request, the frequency of statement production also may change. For example, they may request interim statements (typically quarterly or mid-year) that summarize a reporting period of less than a full financial year.

What’s right for your business?

Financial statements provide a wealth of data and insight into what drives your company’s revenue, profits, and value. Above all, solid financials demonstrate to lenders and investors that management is proactively monitoring financial performance. Contact us to determine what level of assurance and frequency is appropriate for your company based on its current needs.