Small businesses should reconcile their income the same way that large businesses do. Income reconciliations serve two purposes:
They support the amount you owe, or are entitled to as a refund, from tax authorities, and
Supports future business growth - which includes decision making and monitoring cash flow
Let's take a look at the benefits of a formal income reconciliation.
Income - what is it?
Not surprisingly, the definition of income varies. Most businesses consider income something which has already been paid. This is known as cash basis accounting, and it is the foundation tax reporting. Most larger businesses, and all publicly traded companies, also prepare accounts using the accrual accounting method. This method recognises income when services are delivered and matches it to expenditure. Accounts prepared under accrual accounting support the business success and help quantify the success of its products and the health of the company.
When small businesses review their income, they should keep both of these in mind because it will influence the types of decisions they make, and whether they should focus on their product or if they need to focus on their business.
Income for product
Accrual accounting is not normally used by most small businesses; however, understanding its principles ensures that they have visibility on how their business is performing vs. managing their debt. Accrual accounting presents accounts based on business performance, not just the cash coming in. There are three major components to accrual accounting:
Assets are resources a business owns due to a prior transaction. Examples of assets are cash, inventory, and fixed assets such as computers. It also includes financial assets such as accounts receivable.
Liabilities are resources a business owes and are recognised after a prior transaction . These include payables to vendors and loans. It also includes unearned revenue, or services owed to customers who have paid in advance.
Profit and Loss (Income/Expenditure) record goods and services which have been delivered or received. Income and expenditure are recognised even if cash hasn't yet been received.
Profit and loss in accrual accounting can demonstrate the success of a product. High income shows that a product is successful. Small businesses who see that they have high income can take confidence that they are selling something the market is looking for. Profit and loss under accrual accounting does not prove a healthy company.
Asset and liability review will provide important information about the health of the business. If a small business has high accounts receivable, are there problems with customers paying on time? If a business has low cash and high receivables, the business could run into solvency problems and should reconsider how they take payment. High values of unearned revenue could indicate an ability to scale or an inability to deliver business. Small business owners must pay attention to their balance sheets to ensure that the business remains healthy.
Reviewing accounts using accrual accounting is the basis for decision making the future. It provides a much needed separation between the success of the product and health of the business.
Income for taxes
Cash-basis accounting is primarily used to prepare taxes and, as mentioned above, confirm the business is healthy. Cash basis income is simpler to maintain - cash coming in is income, cash going out is expenditure. At the same time, it's sometimes difficult to interpret what those numbers mean.
Reviewing business performance on a cash basis can be appropriate for businesses providing services directly to customers and have little inventory.
What's right for my business?
The right accounting method for your business is specific to your business; however, taking that decision, preparing the right sets of reports, and interpreting those numbers requires proper data management. Often, those businesses using digital invoicing software or ERP systems will prepare accounts using both of these methods, if they're set up correctly! Chayim Messer Consulting provides this expertise to our small business customers.
We are offering a free consultation and a copy of our income reconciliation template. Contact us today!