The Critical Importance of Accrual Accounting

Many dealer-owners completely trust their bookkeepers and accountants to produce accurate financial reports on their operations. This blind faith is not warranted for several reasons:

1. Many bookkeepers are not trained in the Accrual Method of Accounting and resort to the Cash Method because it is easier, inadvertently driving the business in the wrong direction.

2. Accounting software, such as the popular Quickbooks Pro, does not make it easy to input data accurately for Accrual Accounting. Indeed, many unskilled bookkeepers simply click on "accrual," thinking that the printed Income Report will be accurate. Nothing could be further from the truth!

3. Accountants usually are "number-crunchers" and lack the familiarity with the kitchen and bath industry. They often lack the time to properly consult with small business clients. And, they frequently assign "junior associates" to an account that may not have any greater understanding of why accrual accounting is critical to the accurate financial position of kitchen and bath dealers.

Therefore, it's important that dealer-owners conceptually learn the differences between the Cash and Accrual Methods of Accounting and how they impact the kitchen business so they can properly hire and direct professionals to get what they need in accurate financial reporting.

Figure 1 (see above, top) represents a sample job that will illustrate the recording differences and their respective financial impacts of the two accounting methods. A $40,000 job is sold on June 23 with a $20,000 deposit collected. Eight weeks later, the cabinets are delivered and $16,000 is collected. Two weeks later, the job is substantially completed and the client pays the final $4,000 one week later.

Many dealer-owners do not know whether their firm is on the Accrual Accounting Method. The following are indicators that a firm is using the Cash Accounting Method:

--- The Balance Sheet shows huge numbers for Accounts Receivable. (In this instance,your bookkeeper using the job sample in Figure 1 is compounding the financial inaccuracies by posting the $20,000 balance of the sale as an Account Receivable at the same time he/she is recording the initial $20,000 as Income).

--- The Balance Sheet does not show a Works in Process (WIPS) account under Current Assets or under Inventory.

--- The Balance Sheet does not show Customer Deposits account under Current Liabilities.

--- On the Income Statement, the Gross Profit % is considerably higher than what the you might expect from the markup on your projects. Let's say you typically use a 1.54 markup over all costs to earn a 35% Gross Profit, but your Income Statement shows a 45% Gross Profit. This percentage is inflated because Income is being recognized on jobs many weeks before any expenses show up for these jobs under Cost of Sales (see Figure 2 above).

--- Because the Gross Profits are inflated, your accountant says you have made too much Net Profit and will have to pay Uncle Sam considerably more money than you have in your checking account.

All firms should manage their operations based upon Accrual Accounting. However, there are some instances when it may make sense to convert the internal data to the Cash Method for Income Tax filing purposes. Be aware that the IRS will not let firms change their accounting method frivolously.

Once a dealer commits to using Accrual Accounting, it isn't all that easy to implement the change from the Cash Methodology. I suggest consulting with your accountant and then having your bookkeeper work with an expert on accrual input techniques for programs like Quickbooks Pro. You will also have to decide whether to convert mid-year or wait until the beginning of your next fiscal year. If you're 3-5 months into the year, it could take a few weeks to re-post the data correctly. In either case, the rewards of conversion will be huge because you'll finally have accurate financial data to compare your financial performance to others in the industryand lead your firm to its full profit potential.