They didn’t teach accrual-based accounting at Harvard. At least not to undergraduates. I had to learn it the hard way.
When I was a college junior, I managed a student linen service: two pressed sheets (those were the days before no- iron sheets), 3 fresh towels, and a pillowcase delivered once a week to your dorm room: $26 a year, all payable in advance. What a deal – we had 5,000 customers and all of the money came in from concerned moms during the summer, before school even started. I figured that my bottom line for the July-September quarter would be fantastic.
Not so.
Lesson #1: You can’t book revenue that you haven’t earned.
The school year ran for nine months; our revenue was accrued (added up and set aside for the future) during the summer months and then recorded as income over the next nine months. We received$130,000 for our services by September 30 and recorded it on the Balance Sheet as “Unearned Revenue.” Then we earned $14,444 ($130,000/9) for each of the nine months starting in September and recorded it on the Income Statement as we delivered our service.
What about all of those start-up marketing and administrative expenses? They were paid out by us in the first three months, as invoiced, but for accounting purposes they were rolled up into a tidy ball called “Prepaid Expenses” and accrued on the Balance Sheet. Like the Unearned Revenue, they were apportioned evenly and charged out as expenses over the next nine months.
Lesson #2: You have to match revenues and expenses to understand and track your economic model.
The next year, my senior year, I managed another business for which cash accounting would have been misleading. We chartered 18 airline flights and sent 2,000 students, faculty, and staff to Europe or home to the West Coast at various intervals during the summer. At ticket prices of$240- 300 a seat, round-trip, we grossed nearly $600,000.
The airlines, of course, wanted their money up front- a healthy deposit, then final payment at least 30 days in advance, recorded as a Prepaid Expense on our books. To fund this working capital requirement, we had to collect our Prepaid Revenue from our passengers well in advance. But none of the Revenue was earned, and none of the chartering Expense incurred, until the flights actually took off in June, July, and August.
So our financial statements looked strange -cash building up on the balance sheet during the school year offset by liability for Deferred Revenue; and then cash going out in big chunks to the airlines offset by an asset called Prepaid Expense. But no revenue appeared on the income statement until the first flights left in June.
Lesson #3: You can go nine (or even eleven) months without booking revenue, but don’t let that big cash number fool you into thinking that you’re making money.
How did we know we were making money? My full-time secretary and I and the four other students who worked with us tracked it against our budget.
We spread the cost of chartering each plane over a 95% “load factor.” Then we added$40 per seat to cover our overhead – salaries, benefits, rent, phones, insurance, marketing, etc. If we sold our budgeted2,000 seats, we had $80,000 as a “Contribution to Overhead” to cover those expenses. The $80,000 went further in those days(Harvard tuition was $1,520 for my senior year), but even with a reasonable contingency we couldn’t have made it without detailed budgeting, careful monthly tracking of overhead, and periodic forecasting.
Lesson #4: If your revenues aren’t timed to match your expenses neatly each month, you’re flying blind without a 12-month budget.
For every unsold seat short of 2,000, we had to absorb the loss of not only the $40 overhead fee, but also the$200-260per-seat cost that we had to pay United, Swissair, or BOAC.Conversely, for every seat over 2,000, up to the full2,200-seat capacity, we brought $240-300 straight to the bottom line.
It was a marketing game, for sure, but it was also an administrative challenge – no cancellations until the flight was full and your replacement had paid in full.All six of us could do the numbers in our heads – what the bottom line looked like each month was important only in the context of where we thought we would be at that point. The12-month results were critical to the profit-share bonuses that we fully anticipated.
Of the 18 round-trip flights, one was cancelled due to lack of demand, and one went off a few seats short of being full. The other 16 hit the 100% mark, some as early as February or March. It was money in the bank and on the balance sheet, but it wasn’t on the income statement until the flights took off.
Lesson #5: In cash- basis accounting, you record revenues when you receive the cash and record expenses when you pay it out. In accrual-basis accounting, you earn your revenue when you deliver your product or service, and in the same period, you incur all of the expense related to delivering that product or service.
When we drew the line on the charter flight business at the end of August, we had proven the economic model.We had cash left over in the bank, and net income on the bottom line, and when we paid off all of our bills, the two came pretty close to matching…
…or at least they did before an accrual for my bonus trip to Europe.
Alligator Bites
For small businesses, the most common accounting error is a failure to record revenues when earned and to book related expenses as incurred.
Commissions resulting from a sale in February should be booked as an expense in February, even if not paid until later. March rent paid on February 28 should not appear as a February expense.Inventory that comes in the door in January should have been shown as a January purchase on the income statement. It’s the only way to tell whether or not you’re making money.
When you review your monthly financial statements, it’s always helpful to look at your revenues and expenses in the context of revenues and expenses for each of the past several months, account by account.
Line them up on aspreadsheet. Calculate each revenue category as a percentage of total revenue. Do the same for each expense account, also as a percentage of total revenue. Consider the dollar amount against the revenue or expense dollars on each line for previous months. Can you explain the month-to- month variances? Are the percentages – for your direct costs- consistent with prior months? If the answer is no to either, the problem may be a lack of proper accruals.
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Draining the Swamp
You pay your employees on Thursday for the week ending the previous Saturday. Your gross payroll during February(differences due to overtime) was as follows:
| Feb.3 | $36,153 |
| Feb.10 | $38,200 |
| Feb.17 | $35,840 |
| Feb.24 | $37,524 |
| Mar.3 | $44,628 |
| Mar.10 | $37,585 |
What was your payroll expense for the month?
Was it the sum of the 3rd, 10th, 17th, and 24th? Or was it the sum of the four payrolls from February 10th through March 3rd? On a cash basis, it was what was paid out in February, the first four weeks: $147,717.
But on an accrual basis, everything that was paid on February 3was in fact earned through the 29th of January.
Thus the February 10 payroll included January 31st(Monday), plus February1-4, so only 4/5 of that week ($30,560)counted toward February. Similarly, the March 3rd payroll covered the pay period ending Saturday, February 26th, so clearly all of that needed to be included for February. In addition, we needed to pick up $7,517 for Monday, February 28, which was1/5 of the March 10 payroll. So the total accrual-basis payroll for February was ($30,560 + $35,840 + $37,524 +$44,628 +$7,517 =) $156,069. That’s a difference of $8,500in your bottom line for the month – possibly significant.
If you’re not getting fully accrued payroll numbers, you should be. Ask your accounting person why not.