When interviewing prospective clients, I ask, “Are your financials on a full accrual basis?” This question allows me to quickly understand whether they have access to valuable and actionable financial information. Unfortunately, most restaurateurs cannot answer this question because they don’t know the difference between accrual basis and cash basis financials and the impact it has on their success as a restaurant. In this article, we will outline the meaning and importance of accrual basis financials in a restaurant.
Accrual Basis vs Cash Basis
Besides the cheaper price tag of cash-basis accounting, as outlined in How Much Does Restaurant Accounting Cost and Why? accrual-basis and cash-basis financials significantly differ in the narratives they provide.
Accrual-basis accounting reflects your financial performance based on when revenue is earned, and expenses are incurred. Cash Basis accounting reports your revenue as cash received and expenses as cash paid. Typically, the following accounting procedures are added to a full accrual basis accounting cycle in addition to day-to-day reconciliations:
- Record daily sales entries so that the books reflect revenue as of the dates the income was earned
- Record bills so that the books reflect expenses as of the dates the expenses became valid
- Record inventory to reflect the assets (inventory) on hand properly
- Payroll accruals so that the books include the appropriate payroll expenses in the right period
- Other accruals for expenses that have been incurred but not yet paid for, such as amounts due to owners
- Capture prepaid expenses (such as insurance policies) on the balance sheet and recognize them in the appropriate period on the Profit & Loss statement (P&L)
- Capture gift cards, prepaid orders, and deposits as a liability and not report the sales on the P&L until they are redeemed
The accrual-basis and cash-basis financials will show different results. We’ll use a simple unrealistic example to demonstrate the difference. Assume a restaurant opens on Monday, August 7, 2023, and generates $100k in food sales, $30k in food cost, and $30k in labor. The food bills are on Net 10 terms, and payroll is paid every Friday for the previous week. The difference in cash basis and accrual basis would be as follows:
As you can see, the cash-basis P&L reflects the sales and expenses based on when the actual money was received. They don’t accurately reflect the sales and expenses based on the period incurred. Since payroll is processed five days after the period ends, that is when it is expensed on the cash-basis P&L. Since Friday, Saturday, and Sunday credit card deposits from sales are not deposited until Monday, those sales will show up in the following week on the cash-basis P&L. Since bills are not paid until 10 days later, they will show up on the cash-basis P&L 10 days after they are incurred. As a result, cash-basis financials provide a very different and misleading picture of performance. The $57,143 in cash paid by customers is the only number on the financials for that week. On the other hand, the accrual basis financials accurately represent the revenue earned and corresponding expenses for the period.
Under no circumstance should sales tax, tips, payroll tax withholdings, and trust fund taxes be run through the P&L, regardless of the accounting method used. These funds are not the restaurant’s property and should always appear on the balance sheet as a liability. This is a common mistake we see among inexperienced or cheaper bookkeepers. This is an easy way to assess whether your books are correct regardless of the accounting method used. If you don’t see sales tax or tips payable on your balance sheet, you know the P&L is wrong.
Importance of Using Accrual Basis Accounting
The matching principle in accounting says that revenue should be reported in the period it relates to, and expenses should be matched to the revenue they support. It is a fundamental requirement for accrual basis financials and Generally Accepted Accounting Principles (GAAP). Cash basis accounting does not align your revenue and expenses for the reporting period; therefore, it doesn’t truly represent performance for a particular period. It only demonstrates how cash was used.
All restaurant industry key performance indicators (KPIs) and benchmarks are based on accrual basis books. With accrual basis books, you can benchmark your restaurant with industry standards such as food, labor, occupancy, etc. cost as a percentage of sales.
The example below shows the accrual basis versus cash basis versions of the same restaurant’s financials. As you’ll see, the accrual basis financials recognize revenues and expenses in a much smoother and more predictable pattern, because they associate the revenue in the period earned, and the expenses in the period incurred. Cash basis financials only book transactions when the cash transaction happens, creating a much less detailed picture of the restaurant’s performance. The statements below belong to a fictitious restaurant, so you may find that comparing your own restaurant’s accrual versus cash basis financials yields even more drastic results.
Cash basis accounting is not wrong or illegal; therefore, it can frequently be used for tax reporting. However, cash basis financials cannot be used as a business decision-making tool because they don’t provide a meaningful performance measure. This is also why national restaurant chains, franchises, and publicly traded companies require accrual basis accounting.
If you want to get serious about using your financials to manage and grow your restaurant strategically, then accrual basis financials are the way to go. Although you will invest more in bookkeeping and accounting services, the value and ROI you receive due to having key insights is unparalleled. Schedule a call with us to get started with a proven accounting team and get your books on track.