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Real World vs. Computer Realm

 

I recently read the book Ready Player One by Ernest Cline.  The book drew me in from its concept of escaping the real world with a computer, or virtual realm.  In the book there is a virtual realty system where humans can escape from their dreadful existence in a future world that has become poverty-stricken and depressing.  The lines between real world and the virtual world blur, especially as the main character races against the clock to win a competition.

We are in the midst of the Fourth Industrial Revolution, also known as the Digital Revolution.  One day, the accounting software program that your company uses may be fully entwined with the outside sources.  This may easily enable the tie-out of the balance sheet to occur automatically.  However, we aren’t quite there yet.  Therefore, one must still look at the flow of items in the accounting system, both in the real world and in the computer realm.

In other words, your accounting system should include processes for not only the physical flow of documents and resources, but also the technological flow of inputs and calculations in the accounting software system.  The goal is to mirror these as close as possible. Computerized accounting processes must be examined in coordination with real-world flows.

An easy way to look at this is to take the checking account of the business.  If the real-world process involves the collection, storage, and deposit of multiple checks, the software input and output should mirror this.  Same with outstanding items.  If there are checks that have been written and mailed, but not yet cashed by the payee; the software input and output should reflect these outstanding items.  The closer we can get to mirroring the real-world inputs and outputs in the accounting software system, the more up-to-date and accurate output we will have.

Let me know if I can help in evaluating your own system to ensure the real world and computer realm flows are in alignment.

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A Tale of Two Methods

You have probably heard about the “method” of accounting before (also referred to as the “basis” of accounting).  But what does that mean to you?  Your method, or basis, of accounting determines how things are recorded (or recognized) and realized on the financial statements.  To be honest, in the lifetime of a business, the methods used will equal out.  However, in interim years of a business’ life cycle, the method of accounting can have a major impact into the amount of income (or loss) for that specific year.

Understanding the methods of accounting, as well as knowing what method your business follows, can enable better tax planning.  This also means less surprises on tax day.  (No one wants the shock of owing $17,000 on April 14th, when all along they thought their business had a loss for the year!)

Photo Cred: Rawpixel

Cash Method of Accounting

The first method is the cash method of accounting.  Under the cash method of accounting, revenues are not recognized as income until the payment is received.  This may be weeks or longer after the job has been performed.  Expenses are also not recognized until payment is made.  Payment may be either a check written, or a credit card charge incurred.

The cash method of accounting is straightforward.  There is also room for flexibility, especially on the expense side.  If it is more beneficial to incur an expense 20X1, as opposed to 20X2, the check just needs to be written in 20X1.  However, if it is more beneficial for an expense to be incurred in 20X2 instead, you may hold off on writing the check until January 1, 20X2.

Under the cash method, timing is everything!  If you don’t receive payment from your customer until January 2, that income doesn’t get reported to the government (aka taxed) until the following year.  This can be a good thing – who doesn’t like keeping money in their pockets for longer?

Accrual Method of Accounting

The second method is the accrual method of accounting.  The accrual method is used for GAAP (Generally Accepted Accounting Principles).  Under the accrual method, revenues are recognized as income when the job is done (even if payment is not received at that time).  Expenses are recognized when the expenditure is incurred (even if payment is not made at that time).

The accrual method is a more realistic picture of the business’ operations, given that it includes all known and expected revenues and expenses, not just those that have had cash receipts or payments made.  However, there is also less flexibility with timing of recognition.  You aren’t relying on the mailman to determine when your income is recognized.

Tax Planning – Know Your Method

For many businesses, it is most effective to follow the accrual method of accounting to run their business.  It is helpful to know what vendor payments (accounts payable) are coming due, and it is vital to know what customer receipts (accounts receivable) are upcoming.

However, many small businesses may qualify for the cash method for their income tax returns.  Starting in 2018, the threshold to require the accrual method for income tax purposes is gross receipts of $25 million.  This means more small businesses can opt to use the cash method of accounting for their income tax returns.

This is generally good news due to the flexibility with planning.  Many accounting software options, including QuickBooks, allow the dual use of methods.  So, financial statements can be run on both the cash and accrual methods at the push of a button.  However, it is important to keep in mind that net income can fluctuate quite a bit between the two methods.  So even if you showed a loss on the accrual method, you may have taxable income on the cash method, and vice versa.

As you prepare for taxes, be aware of the potential large differences.  I have witnessed business owners that were shocked at tax time because of these major swings of which they were unaware.  Also be aware that QuickBooks and some other software products may have issues if you have entered any journal entry transactions that impact Accounts Receivable or Accounts Payable.

A Tale of Two Methods, or Is It?

Keep in mind that over the business’s entire life cycle, these timing differences in recognition will be eliminated between the cash and accrual methods.  For example, if you delay recognition of a customer payment on the cash method, due to not receiving it until January, you will pick up that income on next year’s return.  In the grand scheme of things, the business would recognize the same total amount of income (just over different years).  The same is true for expenses.

Knowledge is the first step to action.  Now that you understand the tale of two methods of accounting, take action.  Check out what method you use for your tax return (it should be shown on the tax return).  Let me know if I can help at all with understanding your basis of accounting.  You will then be in a good position to take action with your year-end planning.

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Do You Need a Budget?

Are you a living, growing business? 

Are you starting with a tied-out balance sheet and clean financials?

If you answered both questions yes, then my response would be that you do need a budget.

All too often, businesses don’t develop budgeting practices.  This can be ok if the business is established, stable, and doesn’t anticipate a lot of volatile changes in income or expenses. 

However, it can be important for businesses that don’t meet these criteria to have a budget set up, and then monitor against it, to determine if the goals are being met. 

 

Budgets aren’t just for adding pennies to the piggybank!  They are a sophisticated tool to help plan for your business!

 

 

Common Budget Situations

  1. New start up business – must budget in order to even cash flow and know if the business is feasible
  2. Growing business – must budget in order to ensure pricing of product and associated growth can cover rising costs and expenses
  3. Expanding fixed assets, such as equipment or building additions – must budget in order to ensure the expenditures on fixed asset additions can be covered
  4. Struggling business – must budget to ensure cash flow and try to avoid landmines that could ultimately sink the business
  5. Businesses adding managers or decision makers in the process – should budget so these individuals know goals to hit and the available resources and constraints

I have served on the Boys & Girls Clubs of Columbia board for many years.  It is a fast-growing non-profit, that has continued to expand sites and the number of kids served every year.  Rarely have we had a year where we can just assume “same as last year”.  Even though it can be a rough process, every year we develop a budget.  Every month, we evaluate our budget with the actual numbers, questioning major differences (positive or negative). 

Many nonprofits must have budgets and evaluate against them, mainly because there is a governing board ensuring the organization is functioning properly.  I think it is time that more for-profit entities follow their lead and start a formal budgeting process. 

Many software programs, including QuickBooks, can generate budgets and run budget vs. actual reports.  Let me know if I can help you get a formal budget process established.

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Efficient vs. Effective

You have probably heard both words before.  But what do they really mean? 

Dictionary.com defines efficient as “performing or functioning in the best possible manner with the least waste of time and effort; having and using requisite knowledge, skill, and industry; competent; capable”.

Many times, efficiency is touted as something to strive for.  When I think of being efficient, I think of doing something quickly, with little waste of resources.  That all sounds like a good thing, right?

What efficiency doesn’t do is pave the way for innovation.  It doesn’t leave room for self-development, growth, new ideas, or changes.  If someone is so busy being efficient, they don’t have the capacity to focus on being effective.

I would argue that a better goal would be to instead focus on effectiveness.  Note that I am not saying we should throw efficiency out the window, but instead our primary focus should be on effectiveness, first, then efficiency. 

Dictionary.com defines effective as “adequate to accomplish a purpose; producing the intended or expected result”. 

If we strive to be effective, as opposed to efficient, we are still getting the project, job, or work done.  But we aren’t just looking at whether we had wasted time and effort.  Sometimes, in fact I would argue a lot of times, some of the best developments may arise out of effectiveness, not workers just trying to be the most efficient. 

As I started my new venture, I knew that I wanted to focus on effectiveness rather than efficiency.  I wasn’t going to chase down the next billable hour and try to hit time budgets.  Instead, I wanted to invest true time into being effective.  No, this is not time that is billable, but it is useful time that will enable me to learn, grow, and serve my clients in a more effective way. 

Efficient or effective?  What adjective describes your approach to work and why?     

Note: For more insights into efficiency vs. effectiveness, check out Episode #1 of the Soul of Enterprise podcast.  

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Are You Optimized?

What does it mean to be optimized?  To start with, let’s look at the definition of Optimize.

Optimize:            1) To make as effective, perfect, or useful as possible

                              2) To make the best of

                              3) To be optimistic

As I was considering names for my business, I kept coming back to this word.  It spoke to me on several levels. 

1) To make as effective, perfect, or useful as possible

The first definition mentions to make something as effective, perfect, or useful as possible.  This indicates that one must look at the situation.  There is not one solution for every company. 

What works for a $40 million retail company with multiple accounting staff is not going to work for a $100,000 new business with one office manager (who may or may not happen to be the owner’s spouse). 

So, when I work to make something as effective, perfect, or useful as possible, it is considering the existing resources, overall goals and desires, as well as what is needed. 

2) To make the best of

The second definition mentions to make the best of.  Note that this doesn’t say to make the best.  Again, it goes back to the situation and the varying factors at play.  Making the best of is very different than making the best or perfect situation.  Making the best of something considers the factors and situation.  It is also how I approach living my life with a four-year-old.  Not every day will be the best, or will be perfect, but I should make the best of every situation. 

3) To be optimistic

Finally, the third definition describes optimize as to be optimistic.  This too speaks to me with how to approach problems, challenges, and everyday life. 

So, I now turn the tables on you.  Is your business optimized?  Are your systems, procedures, and processes as effective, perfect, and useful as possible?  Are you making the best of your accounting and financial reporting?  Or more importantly, are you making the best of your business’ operations?  And finally, are you optimistic with regards to your business?

If you aren’t, I would love to be able to help you strive to be more optimized. 

 

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Saying Thank You

I grew up being forced to write thank you notes anytime I received a gift.  For the longest time, I didn’t really get the true value of why I was having to write them.  Other than it seemed a torturous practice from my mother.

But I have continued to keep with this practice, even as I have grown into adult and parenthood.  And now, I am starting to pass this tradition onto my own daughter.  Her four-year-old birthday thank you notes mainly consisted of writing her name, but we are practicing all letters and writing words, so stay tuned for her fifth birthday thank you notes!

As I matured, I slowly realized just how much it means to say thank you.  While I still think a handwritten card speaks more than any electronic or verbal communication (and who doesn’t like to get personalized mail), any form of thanks can be appreciated if it is sincere and from the heart. 

So, I want to send a quick shout out to thank those of you who have shaped me along my way.  Whether I have told you or not, I am forever indebted to my family, friends, coworkers, clients, and professional acquaintances.  There have been sprinkles of your influence throughout my life and that will continue with this new career journey of mine.  Thank you from the bottom of my heart for your lessons, feedback, words of encouragement and support, and general caring. 

I would love to hear from you about what’s going on in your life, and what you are thankful for.

Photo by GingerQuip on Pixabay.