Which P&L is better?

Cash-basis accounting tells you when money moved. True-performance (aka accrual-basis) accounting tells you when business actually happened.

Under the cash basis, revenue shows up when the customer pays you. Expenses show up when you pay the bill. This might sound simple, but it can badly distort what’s really going on.

Under the accrual basis, revenue shows up when you’ve earned it. Expenses show up when you’ve incurred them. That gives you a much more honest picture of whether the business is actually making money.

The photos below are an example of the difference between the two methods. One shows the cash basis, and the other shows the true-performance basis. The circumstances for ABC Company Ltd. are the same in both cases.

Under the cash basis, it looks like this company lost money in March and April, but made a big gain in May. This is because they didn’t receive any cash from customers in March and April, but made huge collections in May. In this basis of accounting, the company appears to have earned a combined $60,000 profit for the three months.

What it doesn’t tell you is that the company incurred $30,000 of expenses in May that have yet to be paid. It also doesn’t tell you that the company earned $30,000 of revenue in each of the three months, but just didn’t get paid until May.

Under the true-performance basis, we see the real economic activity of ABC Company. They actually earned a combined $30,000 of profit in the three months, and the profit was a lot smoother across the three months than is suggested in the cash-basis P&L. We are not fooled into thinking the business is more profitable – and on more of a revenue and profit roller-coaster – than it actually is.

If you want your P&L to be truly useful, it should answer this question: What did we actually earn during this period, and what did it actually cost us to earn it? This is true-performance accounting. Cash-basis accounting is just a retelling of your bank statement: it tells you where cash went. Useful, but very much incomplete.

Why should most businesses should use true-performance accounting?

• It matches revenue to the period it was earned.

• It matches expenses to the period they were incurred.

• It gives a truer measure of profitability.

• It makes trends easier to understand.

It helps you make better decisions because you’re looking at economic reality instead of payment timing.

Cash basis is only tolerable for the tiniest businesses with very simple operations. In other words, very few transactions, no inventory, minimal receivables or payables, and not much delay between doing the work and getting paid. You get paid for sales immediately, and you pay your expenses in cash (and not on credit card) immediately. Once a business has any real complexity, the cash basis of accounting starts to muddy the waters.