Leveraging the Benefits of Cash-Based and Accrual-Based Accounting
Make better business decisions by understanding the accounting options available to your business.
By Mike Piekutoski, PT
Have you ever been frustrated by any of the following:
- Significant fluctuations in your monthly revenue per visit?
- Difficulty comparing the performance of a three-pay period month?
- Monthly financial statements that do not align with charges or visit volumes?
Lagging collections giving the appearance a new and growing clinic appears unprofitable for much longer than you expected?
If any of these issues have frustrated you in the past, it may be time to better understand the benefits and shortcomings of cash-based accounting and accrual-based accounting. While your accountant will likely recommend you stick to one system for bookkeeping and tax purposes, using concepts from both can be incredibly helpful for critical business decisions.
This article briefly describes the benefits and shortcomings of each system and, more importantly, discusses how you can leverage accrual accounting principles for making better business decisions even if you use a cash-based accounting.
CASH-BASED ACCOUNTING OVERVIEW
The basic difference between cash-based accounting and accrual-based accounting comes down to timing. With cash accounting, you record income as it is received and the expenses as they are paid. If you provide patient services on January 1 and receive payment on February 15, you will record the income in February since this is when you received the payment. Likewise, cash accounting only records expenses when the money leaves your account, even if the payment was made for services performed in a prior month.
The benefits of cash accounting include ease of use since it is a simplified bookkeeping process. Cash accounting accurately reflects cash management and can even improve cash flow since you do not pay taxes on money that has not yet been received. If patient services are performed in December 2021 but payment is not received until January of 2022, you will not have to pay taxes on the income until 2022.
The disadvantages of cash accounting include limited financial insight and frequent fluctuations in reported revenue. Since revenue is recorded after it has been “earned,” cash accounting provides limited financial insight into business performance, especially during periods of significant growth. An example can be illustrated when opening a new clinic. If a new clinic is opened in January, the lag in payments will make the profit and loss statement (P&L) reflect very little revenue for the first few months of business. As monthly patient visit volumes grow, the revenue recorded on the P&L will consistently lag behind and a cash-based P&L will consistently under-report the net revenue per visit until volume flattens and collections catch up with charges. It could easily take a year or two before a new clinic P&L accurately reflects its business performance in the monthly financial statements. Explaining payment delays and revenue fluctuations to a clinic director can be challenging when using cash accounting, especially in a situation where incentives are tied to clinic profits.
ACCRUAL-BASED ACCOUNTING OVERVIEW
Accrual-based accounting records income as its “earned” rather than when it is received. It also records expenses when they are incurred, not when they are paid. A clinic that treats 1,000 visits in a month would record the anticipated revenue from those visits in that same month. This is typically done by using the historic percentage of collections or an average net revenue per visit. Because the revenue recorded is an estimate, it is critical to stay on top of collections to ensure that adjustments are made when appropriate.
The primary advantage of accrual accounting is that it provides a more accurate picture of your company’s profitability and financial health. Since revenue is recorded as it is earned, the monthly P&L will align more closely with clinic metrics. A month with record patient visits will have record revenue in that same month. This is much easier to explain and understand on many levels.
While accrual accounting provides a more accurate picture of how the business is performing, it has disadvantages as well. Disadvantages include being a more complex system and the potential difficulty tracking cash flow compared to cash accounting. If payments are delayed due to factors outside your control such as insurance denials, delayed payments, or changes in payment rates, or a delay from a payor, your P&L may significantly overstate (or understate) your revenue and may require periodic “true-ups” to correct for those factors.
Accrual accounting can have both tax advantages and disadvantages in certain situations. An example of an advantage is an owner who orders equipment in December and wishes to account for that expense in that same year. With accrual accounting, the expense can be recorded in December and potentially reduce the tax liability for that same year. A disadvantage is that payments are recorded before they are received. This can accelerate tax liabilities and lead to paying taxes on revenue that has not yet been received.
Table 1 outlines the difference in accounting methods for a new clinic that generated $80 per visit and had increasing visits over a period of five months. Using a cash accounting method and with payments lagging 30 to 40 days due to insurance processing, the revenue collected each month will be less than the accrued revenue each month. When calculating net revenue per visit, it will appear to be significantly lower than the expected collections at maturity.
HOW TO LEVERAGE BOTH CASH AND ACCRUAL ACCOUNTING PRINCIPLES
For businesses over $25,000,000 in revenue, the IRS requires accrual accounting to be used. For those under $25,000,000 in revenue, you should discuss the pros and cons of each system with your accountant and even consider using a combination of both systems.
- By using cash accounting for bookkeeping and tax reporting, you can leverage the benefits of bookkeeping simplicity, cash management, and avoid paying taxes before money is collected.
- You can then use accrual accounting principles to summarize and assess financial performance against past performance and industry benchmarks.
TRY THIS MONTHLY HACK
If you are using cash accounting and want to gain better insight into your business performance, consider assessing your P&L using this simple hack to estimate your monthly revenue:
- Export your P&L into Excel. Make a second copy so you can compare the original cash-based with an accrual-based P&L.
- In the cash-based version, use your monthly patient visits to calculate your net revenue per visit. In the accrual-based version, replace the revenue with an estimate for accrued revenue. This can be done by using a percentage of charges, historic net revenue per visit multiplied by visits, or more complex calculations depending on available data and internal resources.
- This alone can be very insightful with regards to assessing financial performance.
If you have 26 pay periods and want to use accrual principles to compare months with two vs. three pay periods, you can simply adjust your wages using the following steps:
- For months with two pay periods, divide your wages by 20 days (10 days for each pay period), then multiply your daily wages by the number of days in that month. A month with 22 days will result in an additional 10% in estimated wages. For example, $40,000 in wages / 20 days = $2,000 per day. $2,000 x 21 days = $42,000 in accrued wage expense.
- For months with 3 pay periods, divide the total wages by 30 (10 workdays for each pay period), then multiply the average by the number of days in the month. This will result in a lower wage cost for that month. For example, $60,000 in wages / 30 days – $2,000 per day. $2,000 x 23 days = $46,000 in accrued wages.
- Simply replace the original wage expense with the new calculation.
While these two adjustments do not provide a true accrual P&L, in less than five or 10 minutes, you will have accounted for the two largest variables in your financial performance (revenue and wages). This will provide a solid estimate of the financial performance with less monthly fluctuation while still leveraging the benefits of cash accounting as your “official system” for bookkeeping and ax reporting.
Mike Piekutoski, PT, is an M&A Advisor with 8150 Advisors. He can be reached at mikep@8150Advisors.com.