Many businesses start with rather haphazard accounting practices, especially when it comes to accounts payable and accounts receivable. If books are maintained at all, odds are good the business is using the cash basis accounting practices, instead of the accrual method. And this can wreak havoc on accounts payable reports, especially as a business grows to a firm with annual revenue in the millions. How can you improve your accounting department's accounts payable procedures to make them more efficient?
Exploring Cash Basis and Accrual Accounting
First, it helps to understand the difference between cash basis and accrual accounting. Cash basis accounting is typically used by very small business owners and sole proprietors.
In cash basis accounting, revenue is reported when cash is received, and expenses are reported when cash is paid out. In accrual accounting, revenue is reported when cash is received, but expenses are reported when they occur.
Accounts Payable: Why Accrual Accounting Matters
As you can see, there is one small (in process), but large (in principle) difference between the accounting methods. (There are others, but we won't go into them for the purpose of this blog.) Let's see why it makes a big difference in budgeting and profitability for a business.
Let's say your accounts payable is often late, and you let your phone bill slide for three months. Now you're paying a phone bill three times the usual size, all in one month. And, if you're using cash basis accounting, you're recording the expense in that month, too. Your expenses for the two prior months will seem unusually small, while your expenses in that third month will be artificially inflated.
This makes a big difference, even if you pay your bills on time, if you have Net-30, Net-60, or Net-90 terms with vendors. It can also make a big difference in your accounts payable financial statements when you file and pay quarterly taxes.
Most importantly, it doesn't match expenses incurred with the related income they may help to generate. This is especially important if you have inventory, if you are a contractor who buys project-specific materials, or even if you're a technology company that has to make large investments in hardware, software, or talent for specific product development or launches.
A Better Way To Log Accounts Payable
When your accounts payable department shifts to accrual accounting and begins logging expenses when they are incurred, it makes it easier to:
- measure your company's profitability in any given time period
- perform job costing functions
- reduce specific expenses, because you can spot them more easily
- perform financial forecasting
As a business grows, aspects of accounting practices that didn't seem important become critical to success and continued growth. The downside? Not every business owner or part-time bookkeeper understands how to use accrual accounting. This could be an indication that it's time to invest in an accounting service that can manage your accounts payable the way it should be done, along with providing all the other accounting services that rapidly growing businesses need.