Understanding Accrual Accounting
January 17, 2013 Leave a comment
You all get a treat today, a guest blog by financial executive, Charles Seeman. He wrote a great case study previously on this blog that get a lot of attention. So, without further ado…
When I was a young junior staff accountant for a large regional CPA firm I, like all other junior staff people, were assigned to do “write up” work for some of our clients. Some of the older business people would play a game with junior staff accountants like me where they would tell us that they can guess the final net income number and be within a couple of thousand dollars of what is calculated by accrual accounting. At their skill at this amazed me, but after a while, I understood completely how this was done.
The purpose of this blog entry is to help young entrepreneurs understand and thus be able to predict how their business is doing. I want to help young entrepreneurs avoid the trials and tribulations that those older business owners endured to learn the skills necessary to be able to truly understand their business and how revenues and costs work.
First, it is important to note two things about costs;(a) costs generally follow a pattern. For example, if the products you sell costs approximately 50% of your selling price in one month there is an excellent chance that the products you sell will cost you somewhere around 50% every month Thought, individual product markup can change from month to month, the overall business’s cost percentage is very difficult to change from month to month.(b) Many costs are incurred every month and at exactly the same amount. For example, your rent usually will not change from month to month and in most business’s even costs like overall payroll costs tend to stay approximately the same from month to month. Surprisingly revenue tends to follow some predictable patterns also. This allows for a reasonable estimate of the amount of revenue reported each month. Most established businesses serve the same clients each month and /or have established patterns of advertising their products or services to its customers. Since for the most part, advertising drives revenue the established pattern of advertising will create a pattern of customer activity and this creates a predictable pattern of revenue generation.
Secondly, the new entrepreneur needs to understand the importance of accrual basis accounting and why accrual basis accounting is far superior to cash-basis accounting in helping entrepreneurs understand their business. At this point, you are asking yourself accrual basis accounting-cash basis accounting what is the difference. Simply put, cash basis accounting records both revenue and costs when they are paid not necessarily when they are incurred whereas accrual basis accounting records both revenue and costs when they are incurred. Incurred-paid what is the difference?
So how can knowing that both revenues and costs behave in predictable patterns help young entrepreneurs manage their business?
–Charles Seeman is currently CFO for AvuTox Laboratories, a full service clinical laboratory that offers pain management drug testing profiles that provide physicians with information relevant to patients on pain medicine. He is a financial executive with a passion for and a proven ability to provide strong innovative leadership. He posses a unique ability to view the organization from a 360º enterprise prospective, a strong ability to adapt to any business environment, and a unique combination of superior technical skills and business management skills. You can connect with him on LinkedIn or email him at email@example.com.