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Part 2: Cash or Accrual? Is your A/E Firm Using the Right One?
In Part 1 of Cash or Accrual we defined and provided examples of the difference between cash basis and accrual basis accounting for your A/E firm. We also started to discuss the importance of collecting on invoices for past services provided and how earning cash—meaning getting cash in the door—can tend to be more of a challenge for A/E consulting firms than it is for companies in other industries that provide goods or services.
Keep in mind, at the end of the year your accountant may be able to use either accounting methodology when filing taxes based on which is most advantageous for your firm from a tax perspective. But that is not what this article is about. This article is strictly about which accounting method your business should use to track its financials for day-to-day operations. This will, in turn, provide you and all interested parties with the type of financial information you need to make important decisions for your company. As always, consult your accountant for any financial decisions that may have a tax implication.
One major difference between cash basis and accrual basis is a project’s date of completion. Due to the nature and established industry standards of the A/E field design, drawings are performed, completed, and issued for a building permit or construction before a project is invoiced 100%. However a project’s circle of life (as discussed in part 1 of Cash or Accrual) is not complete until payment has been fully received. Meanwhile, in the client’s eyes, the project is complete when they receive their building permit and construction drawings. And in the consultant’s eyes, the project is not complete and cannot be closed until all fees on that project have been collected.
In cash basis accounting, the project is complete once all invoices for the project are paid in full. The income for that project is recorded when cash is received and the project is closed. By identifying the true life cycle of a project and using cash basis accounting to reflect that life cycle, your business is able to make important financial related decisions based on projects fully completed and closed out (i.e., fully paid-for projects) rather than based on projects you’ve completed the consulting work for. This rules out projects you may not expect or even hope to receive payment for at some point in the future. Some decisions benefit from this knowledge. Examples include employee bonuses, whether to invest in a new expense for business growth, and any other cash flow-related business questions.
Sounds like cash basis would be a perfect fit for your A/E firm, but where does it fall short? While using cash basis accounting, a company looks successful when you collect payment and doesn’t look successful when your company doesn’t collect payment. Imagine your company received, say, $100,000 in outstanding invoices in the month May, but that it only collected $50,000 in the month of June. A quick view of those numbers says the month of May was a very successful and busy month, but that June was not. Those numbers don’t tell you that 50% of your May collections were from overdue invoices that finally came in. That extra 50% bump in cash was due to past work completed and possibly additional efforts made by the company to collect on outstanding invoices.
This is where accrual basis accounting comes in. As an A/E business owner you want to be able to track trends in sales, production, and collections. Accrual based accounting allows the business to quantify the value of work the company performed in a given time period. If the firm was slow during winter, but crazy busy in the summer, accrual based accounting would reflect that.
The answer may be both! I know what you’re thinking, the title of this article is Cash vs. Accrual, and there has to be a winner. Nobody likes ties, except for soccer fans. Hey oh! It’s okay, I’ve played soccer all my life so I’m allowed to make fun. The truth is: each A/E firm is different and each firm must use some means to track both the company’s sales and production and cash flow.
Typically, smaller firms lean towards the cash basis approach and larger firms lean towards the accrual basis. One explanation is that larger firms are able to have indirect labor employees who manage invoices and cash flow (or possibly because the government makes them – we’ll get to that topic shortly). If you’re a smaller firm, and the person running and following up on invoices is also the company’s principle or someone wearing multiple hats, cash basis is the better way to go. In that scenario your accounting numbers reflect the state of your company and directly answer the question, “How much money do we have in the bank?” As a small business owner you still need to arm yourself with business metrics that help you plan for the future based on past financial information. Even though you run your company on a cash basis, your business should still track when the work for projects is started and completed, which is done by tracking how much work was completed in a certain period of time. This approach is no different than using accrual based accounting and at the same time closely monitors cash flow and accounts receivable. The question really is: how do you want your financial information to be delivered to you and all interested and invested parties?
Before deciding cash or accrual, consider the A/E project life cycle. What is most important to your firm, based on your firm’s operations and biggest struggles? If collecting is an issue for your firm, which is a continuing challenge for many small firms, then you should probably use cash basis accounting.
To wrap this discussion up let’s ask: what does the IRS (“Uncle Sam”) allow you to do? Keep in mind, these restrictions are for tax purposes only. You should consult your accountant first, but you should be able to run your business’s financials with whichever method fits your company best. Per the IRS Revenue Procedure 2000-22, as of May 2016 companies with an average annual gross receipts of $1,000,000 or less are not subject to restrictions on which accounting procedure they use. Average revenue is based on revenue from the last three years of the company. If you haven’t been in business for three years, the IRS will look at what years you have been in business, including partial years.
If your firm averages more than $1,000,000 and has a physical inventory to account for, you generally have to use accrual based accounting. However this typically does not affect the A/E industry. One final restriction that could affect your A/E firm: if you are C Corporation and average over $5,000,000 in annual revenue, you are required to use accrual based accounting. Let’s hope one day your company has the problem of being forced to use accrual based accounting. Then, congratulations! Your business is successful. These are the main restrictions. As always, and I can’t stress it enough, be sure to consult your accountant. We all know you wouldn’t go to an architect or structural engineer to do your taxes, right?
Let us know your thoughts on cash vs. accrual basis for your A/E firm. What works for you and why? I look forward to continuing the discussion. Our next Business Metrics article will be on “Bad Debt,” which will continue our focus on collections in the A/E industry.
Aaron Mitchell, PE, SE
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