Chapter 6
Accrual, cash and tax basis

Business owners often ask, “If I pay off my bank debts, I can count that off on my taxes, right?” The question exposes a fundamental misunderstanding of the “basis of accounting” financial statements are built upon. Learn the difference between the three main bases of accounting — accrual, cash and tax — and your understanding of financial statements will grow dramatically.
So far, we have discussed the three basic financial reports — profit and loss, balance sheet and cash flow statement. In doing so, we have referred to the accrual basis. But what does it mean?

A basis of accounting is nothing more than a set of rules that the accountant follows in preparing the reports. It tells him when to count certain transactions in the records, and how to do it.

The “when” is the biggest difference between the accrual method and the cash method of accounting. The “how” is the biggest difference between the accrual method and the tax method.

The American Institute of Certified Public Accountants (AICPA) developed accounting rules over time. Between generally accepted accounting principles, known as GAAP, and the actual rules established by various professional and regulatory boards, there’s a set of practices to help all companies report profit and loss in basically the same manner. This allows for apples-to-apples comparisons between companies.

For companies with publicly traded stock, the financial statements are the only real measuring sticks for investors. Inaccuracies or inconsistent practices lead investors to make the wrong decisions — and then lead them to the courthouse. To keep companies and their managers honest, the Securities and Exchange Commission and the AICPA require all companies to report profit and loss in the same manner. These rules are frequently referred to as GAAP. Accountants must comply with these rules — and disclose in their reports when they are violated — or risk losing their licenses.

Even privately held companies must follow most of these rules. Thus, your accountant gets mighty nervous if you suggest — knowingly or unknowingly — a treatment or practice of accounting that breaks the rules.

The three bases of accounting that might be used to prepare your fleet’s financial statements are accrual, cash and tax.

Accrual basis means that a transaction is recorded when it happens, regardless of when cash actually changes hands. Recall the example we used in the last chapter about how you might treat the revenue from a single haul. The accrual basis records the event when the haul is completed. The accountant enters the revenue on the P&L and logs an accounts receivable on the balance sheet. When the cash finally comes in, there is no further effect on the P&L. But the balance sheet changes, as accounts receivable is reduced and cash is increased.

Thus, the accrual basis “matches” revenues and expenses in the same period. You record your revenue when your hauls are completed, whether or not the money comes in during that period. Likewise, you record your expenses when you incur them. Some you pay in cash, some you might owe as accounts payable.

Most companies use accrual basis, especially as they grow. That’s because banks and other lenders typically require you to report under the accrual basis in the loan agreements you sign.

The bigger the loan, the more lenders have to lose, so the more they insist that you tighten your accounting practices. As we’ll see in Chapter Eight, for loans of $1 million to $3 million or larger, lenders often require a review statement by an accounting firm. Since reviews (and audits, too) require the accountant to list any departure from GAAP or accrual, you must move to full accrual-basis accounting at that point.

Cash basis means that you don’t record a revenue or expense item until you receive or write the check. Continuing our example, if you use cash-basis accounting, you don’t record anything when you complete the haul, unless, of course, the shipper or receiver pays on the spot. When the check arrives, you record it on the P&L as revenue and on the balance sheet as cash. Few companies use the cash basis to keep their books, and there are lots of reasons not to.

First, it doesn’t give a clear picture of real profit or earnings in a given month or year. Because it doesn’t match expenses with revenues, using the cash basis can lead to poor business decisions. What looks like a profit can really be a loss. And what’s deposited into your checking account does not equal your profits.

Second, your bank may not allow you to use the cash basis; it wants to know what you’re earning or losing, and the cash method isn’t a good indicator of that.

Third, the Internal Revenue Service may not allow you to use it. They want you to report on the accrual basis, which doesn’t let you manipulate income as easily as the cash basis.

Tax basis means that the rules of the IRS are used in deciding how to record transactions. Essentially, your businesses’ P&L mirrors that of your tax returns. For most companies, this is a modified version of the accrual basis. Rarely, a company might use a tax basis based on the cash basis. Businesses that do generally are very small; many leased owner-operators use it.

If your company’s annual financial statements are presented on the tax basis, it’s probably because your bank has consented to the practice as a way to save you money on accounting fees. Your accountant saves time and effort if he uses the same basis of accounting for your published financial reports as he does for your tax return.

The main difference between the accrual and tax bases is how you calculate depreciation. In addition, sometimes tax rules won’t let you deduct an expense in the same period that you record it under accrual-basis reporting. This means your accountant may have to maintain two sets of numbers. That’s not as hard as it sounds, however, given the capabilities of modern software packages. But it still takes time, and to save on accounting fees you might elect to have your reports prepared on the income tax basis of accounting.

To help understand the differences between the three, there is a brief table on the next page showing how some P&L transactions might be recorded under each method.

Another difference between accrual and cash basis: Accrual-basis financial statements list accounts receivable (and other miscellaneous current assets) and accounts payable (and other miscellaneous accrued expenses), but cash-basis statements do not.
You may have noted another twist, which shows up in the table: The cash basis records some transactions just like accrual. And depreciation expense and bank loans are treated in a similar manner.

In the case of depreciation expense, you must record and allocate the cost of long-lived equipment over several years, regardless of what basis of accounting you use. That’s because the purchase benefits more than one accounting period. Writing it off in the year of purchase would show great losses in year one and just-as-inaccurate “profits” in later years. (More on this in Chapter Seven.)

Now, back to the common misconception about how bank loans are treated. Loans aren’t treated as income, so you can’t record them as revenue on the P&L (nor, for tax reasons, would you want to). Rather, you record them as liabilities, even if the books are on the cash basis. And when you repay the loan principal, there is no P&L entry because it’s a payment of a liability, not an expense. There is a P&L entry for any interest on the loans, since that is considered an expense.

In Summary
The bases of accounting are important, because there are critical differences between them and how the financial statements look under each method. The reader must know the method in order to know how to read and interpret the statements. Failure to understand these matters can lead you to misinterpret your financial statements — and worse, possibly make poor business decisions.