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Cash or Accrual? Is your A/E Firm Using the Right One?
It is fair to say that many small business owners in the architecture and engineering (A/E) consulting world, like yourself, never took a class in accounting. It’s also just as likely that you never took any classes related to business. Our course work was nothing but our focus: architecture or engineering. For some of us, including myself, it took more than the standard four years of college to complete our undergrad and earn a degree in architecture or engineering. Who among us had the time to do anything else but architecture and engineering? If you answered “I did” to that question, well you’re an all-star and you’ll have to tell me how you did it!
As an engineering major, and likely for other majors, we weren’t just taught engineering in school, but also how to learn and teach ourselves. My engineering school in particular, Ohio University, knew they couldn’t teach us everything about engineering, so they maintained a focus of requiring their students to research and learn on their own.
Whether you’re a practicing architect or engineer fighting in the trenches, thinking about starting a firm, or are already an owner of an A/E firm, you have likely made yourself successful by continuing to learn about your profession and business on your own. Whether you received help from others or not, you made decisions to continue to better yourself and your profession. This article is just one more step in the direction of continuing to better yourself professionally.
Sounds like something an accountant would ask you. Well, that’s because we’re talking about accounting. Specifically, we are talking about Accounting 101. But how do these accounting methods apply directly to businesses in the A/E industry? Is either method more suitable for the A/E profession, a service industry? Before we dive into those questions lets define what each accounting method is.
Cash Basis Accounting:
Profit is not earned until payment is received. The completion date of the service you provided has no bearing on when income is considered to be earned. Just like income, expenses are accounted for in the same way. An expense is incurred when payment is made. When your business receives a good or service which incurred that expense has no bearing on when the expense is considered to be incurred by your business.
For example, your A/E firm just completed the design and drawings for a two story office building and you issued the drawings for construction. Construction administration services were not included and so your firm is 100% done with that project. Even though your firm has fully completed its scope of work, you have not received any payment for this project yet. With cash basis accounting you have not earned anything yet, because you have not received payment. Hopefully your client is good about paying their bills and they pay within 30 days of invoicing. When you receive payment 30 days later, the income from that project is then considered to be earned on the date you received payment.
An example for expenses would be if your company needed to buy two AutoCAD licenses in the month of July and your company paid for that expense on a credit card. You pay off that credit card in August. Similar to income earned, that expense is not incurred until August when you pay off the credit card, not in July when you receive the licenses and are able to start using them.
Accrual Basis Accounting:
Profit is earned when a good or service is provided. When payment is received has no bearing on when income is considered earned. Expenses are incurred when a good or service is received. When payment for that good or service is made has no bearing on when that expense is considered incurred.
If we consider the previous examples, but this time with the accrual method, the income earned on that two story office building you designed and issued drawings for would be considered earned on the day you sent out the drawings and completed the project. Where this accounting method can become tricky for smaller A/E business is if your client isn’t actually good at paying their bills promptly and you don’t receive payment until maybe 120 days later. If you’re not clear on how you read your accounting information, situations like this could lead you to believe your company is highly profitable and has cash on hand, but that may not be the case.
For the A/E business there is a circle of life that exists for every project. A project first starts as an opportunity with an RFP. Then it either lives on with your firm being awarded the job, or your proposal is not accepted and the project dies. For awarded projects, you then execute your professional services. The next step is collect the fees you charge for that service. Once your company has fully collected, and hopefully your client is happy with the service you provided, more RFPs should follow. A successful A/E firm is able to complete and repeat that circle over and over. Notice that collections is key part of that progression. The whole reason a business exists is to earn money. If that business never collects, it is not fulfilling its main reason for existence, and essentially fails.
Since A/E businesses are service providers and typically do not get paid until after their service has been completed, receiving payment can be a difficulty. A/E businesses do not produce widgets or physical products. We do not perform work on physical objects. We produce designs and drawings, which nowadays are often delivered as electronic PDFs. Other business types are able to receive payment upon sale of their widget or physical product, or if they perform work on a physical object, such as a car, that car can be held from the client until payment is received. The latter example would be known as a mechanic’s lien. Granted we could withhold our drawings from being issued until payment is received or require payment upfront before starting, but that is just not the industry standard for the A/E consulting world. The majority of A/E businesses don’t require either of those two options. If you did, a potential client would likely tell you to go fly a kite, since he can find less restrictive architects or engineers to take care of his needs.
A small A/E firm’s biggest problem is first finding the work. The second most important problem is getting paid for their work so they can in turn pay for operating expenses and earn a profit. With cash being so important to an A/E business, cash basis accounting gives the true pulse of your A/E business. Maybe you just sold $100,000 of work last month, but your account balance is below $10,000 and payroll is coming up in a week. Which number is more important? In this example if your accounting system was accrual basis, it’s telling you that income is good and you’d be thinking, “Great, we are straight up killing it!” If your accounting system was cash basis you would probably be saying, “Oh S#!T!!”
Now, cash basis accounting isn’t necessarily the end all be all for your business. Accrual basis accounting has its advantages over cash basis and if properly matched with active cash flow analysis, accrual basis accounting can work.
In Part 2 of this series we will take a closer look at the advantages and disadvantages of both cash and accrual as they relate directly to the A/E industry. We’ll also examine when Uncle Sam forces you to use one or the other accounting method.
Aaron Mitchell, PE, SE
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