Using Accrual Accounting to See the Full Picture of Your Business

Before we go in too much further, let's talk a little bit, I'm gonna talk briefly, we'll go back to the beginning a little bit on today's workshop. We're gonna be a little bit more instructive today than we will in the following session. We're gonna have three workshops in this series. Part one, you are here, we're gonna talk about accrual accounting specifically as it applies to ecommerce. Part two, we're gonna talk about how to use your profit and loss to make better decisions. So that's gonna be much more interactive. I would invite you, if you're using QuickBooks Online, on part two to be ready to follow along, because I'm gonna be going through and running reports, and I hope you'll run them with me.

1:20

Part three will be how to use your balance sheet and cash flow statements. Now, when we set out this workshop series, we originally thought, let's just jump into the profit and loss. But as I started to think, I said, if you don't understand accrual accounting, running those reports and analyzing the data isn't going to help. And so for that reason, we decided to do this part one.

Now, by way of action, where this is gonna be a little bit more instructive and less interactive, what I would say is I want to get your questions. There's a couple ways you can ask me. There's a question and answer option in Zoom. If you've never been in a Zoom webinar, I would encourage you to use it there. You can put things in the chat, but I would prefer if they came in through question and answer with me. I have Kelley, she's gonna help me and kind of work with you guys.

2:17

If you need help with your accounting, I know I have some of our current customers on here. Hello, I'm so glad you joined us. I wish I had all of our customers here. And I'm gonna invite them in the future directly. If you need help with your ecommerce accounting, reach out to us, we'd be happy to help. Easiest way to do so is ledgergurus.com/services and click talk to us.

Alright, diving in. The goal for today's workshop, I want you to walk away understanding why you should use accrual accounting. I want you to understand how it works, so not only why you should use it, but understand what it's saying. Because when we get in workshop parts two and three, you're gonna understand what you're looking at. I want you to learn how the three financial statements work together. And I want you to see the statements in QuickBooks Online, because the next two parts of workshops, we're gonna go very heavily into those. I'm gonna wrap up the current poll. Thanks for those that answered, because I'm gonna ask you a follow-up question.

3:32

Alright, so the next poll that I want to ask you is, I need an understanding of what your background is, and I really would love it if I had all of you respond. So take a minute and tell me, what is your accounting education? Your choices are, I have never taken an accounting class in my life. I have taken an accounting class, or maybe more than one. You may have a degree. Or maybe you're a smarty pants and you full on have a CPA or a CMA, Certified Management Accountant.

So I'm gonna run this for 30 seconds or so. Let me tell you, if you answer, I have a degree, this may be somewhat remedial and you may want to drop out and skip ahead to part two and or three. I will not be offended if you stick around. In fact, I'm intimidated. I would love for you to jump in with thoughts or comments if you have them. I'm going to be going into specifics as they apply to ecommerce accounting. If you've never taken a class, this will be a little bit heavy, but I'm gonna try really hard to explain it.

4:44

And I see a lot of you have taken a class or even have a degree. That's awesome. And so hopefully the concepts that we're gonna discuss here will make a lot of sense, and this will be a review and a reminder. So I'm gonna let this continue to run for a few more seconds. Again, consider this like introduction, the prerequisite class for the following two workshops where we're gonna just go in and look at the data. And if you don't understand accrual accounting, you're gonna have a hard time on workshop part two and three. So I'll let this continue to run for a minute.

5:36 Why accrual accounting, and why not

Stephen Brown

Okay. So we are an ecommerce focused business. The focus of our examples and the education here will be around ecommerce. So if you took an accounting class, they love to talk about like manufacturing and widgets and stuff like that. All the examples I'm gonna use here are ecommerce specific.

Now, the question you may want to ask, or you may wonder going into this, why do accrual accounting? That's a good question. Well, let's answer that question. So first off, measurement. Second, do you need a loan? Third, you plan on selling your business. Or fourth, taxes.

Measurement. It's really hard to understand profitability, especially if you're doing ecommerce, without accrual accounting. And I'll show you why. Furthermore, it's really hard to understand how efficient you are in your business. I can go into a business that has good accounting, and I can tell you, an ecommerce business in particular, I could tell you exactly where your problem is. Give me like three minutes. I could probably say, this is where you need to work on in your business, just by analyzing your profit and loss statement. I've done this for a number of customers.

6:38

If you're a customer of LedgerGurus and you'd like to reach out to me specifically, you can hit up your accounting manager. You can hit up the contact us. I will sit down with you for an hour and I'll tell you exactly what I'm seeing in your business. And that's because accrual accounting makes it really easy to analyze that.

Second, you need a low cost loan. So again, ecommerce, there's a lot of easy loans. Shopify, Amazon, whatnot. Easy money is usually not good low cost money. So when you go and get a good loan from like the SBA or a traditional lender, oftentimes they want your financial statements and they want them to be in accrual format.

If you're planning on selling your business, during, you know, 2021, 2022, there was a whole lot of sales of ecommerce businesses. Buyers expect you to have accrual accounting, and they expect it for multiple years. And finally, there are certain tax requirements based on your revenue threshold, based on inventory accounting, based on the type of business you are, that will require it.

7:53

The main reason that I want you to learn accrual accounting and learn how to use your financials is for point number one, though. It's so that you can understand what's going on in your business better.

Alright, let's talk about why you wouldn't do accrual accounting. Well, it is more expensive. A lot of people ask us when they come and work with us, they're like, why is ecommerce accounting so expensive? And it's because you really need to do it accrual based. There's some businesses, like LedgerGurus, an accounting firm, that you could probably get away with cash based accounting and not lose a whole lot. But ecommerce cash based is a nightmare. You have no sense of what's going on, and it takes a lot of work. And I'll show you kind of the different areas of where you have to do work. So anyhow, I'm gonna wrap up our poll. Thank you for replying, those 78% of you that decided to do so. Go ahead and share the results for those that wanna see 'em, and then we will move on.

9:10

So while you're looking at those results on the side, I wanna tell you my journey to understanding, appreciating accrual accounting. 20 years ago, actually 18 years ago, I went from a software engineering job to a product management job. And product managers, what they end up doing is they end up defining what goes into a software product. But they also, especially back in that day, we spent a lot of time working on pricing and all this other stuff. And I went to pricing committee. I had a product that was gonna launch and I was like, okay, this is the price it's gonna be. And they started talking about revenue recognition. And I was like, what is revenue recognition?

So back in the day, we were selling licenses and software maintenance, and we would sell it and somebody'd have to pay, you know, a hundred grand. It was big enterprise software. They'd pay a hundred grand up at the beginning of the period. And they were talking about revenue recognition and how that would actually be posted as revenue. And I was like, what? But we got paid, didn't we? No, it gets recognized over a 12 month period. The way it works is you divide it up by 12 and apply that revenue over 12 months. But I was like, but we got all the money up front, right?

10:25

And I proceeded to go into one of the finance guys' office a little bit later, and I'd never taken an accounting class in my life. So if you're in that category, I know some of you are, and some of this is hard, I'm gonna try my best, but accrual is kind of weird. And he proceeded to whiteboard and try and explain how that worked. And I kind of got it. But essentially the concept was, sure, we get all the money, we get the cash whenever, but we need to really spread it out from an accounting perspective over time. Now, I've got some slides here in a minute that's gonna illustrate why spreading out revenue or expenses or cost of goods sold makes sense. But when you first look at it, you might be kinda like me, scratching your head like, I think I get it, it's weird.

11:17

Well, a few years later I got myself an MBA, go Utes. I ended up going to a startup with some guys that I'd worked with before. I ended up becoming the president of that company, because the previous guy, who was a sales guy, had kind of, was trying to grow through just sales spending. He just spent on sales, spent on sales, spent on sales and marketing, and my CEO and the board member said, we need to make a change. The powers of accrual accounting I was able to use for budgeting and forecasting, and I was able to keep that business alive. They ended up being acquired a couple years later. And I really attribute a lot of that success to my newfound skills that I had obtained through MBA school in finance and accounting, because I was able to actually read my financials. I was actually able to project sales and cash and problem solve.

12:08

A few years later, my partner and wife, Brittany, who some of you may know or know of, started LedgerGurus and sucked me into this crazy world of accounting. But I loved it, because it had made a huge impact for me in my career, enough to where I said, hey, let's do this. I'll quit my job in software and let's go help the world build better businesses through better numbers.

12:50 Cash versus accrual with two examples

Stephen Brown

Alright, so cash versus accrual accounting. I'm gonna get down into the nuts here. So if you're like struggling a little bit with my previous example, that's 'cause I just kind of touched on it. Let me show you two examples, and then we're gonna really dive in. And again, I would love for you to ask me questions. We're gonna get into a point where it's like, I really need you to ask me questions if you're struggling.

So let's do two examples in ecommerce, and I'm gonna show you a very simplified profit and loss or income statement, and show you some activity that's going on here. Now, if you need a little refresher, revenue minus cost of goods sold minus expenses equals net income, or profit, okay?

13:34

So April, I make the first payment on an inventory order. And this is cash-based accounting. So I have to pay $250,000. And then in May I received $500,000 for a wholesale order. So let's say I got a Costco, or you know, pick your favorite wholesaler, and they gave me a big purchase order and they paid the entire order upfront. And then I had to pay the second payment for my inventory order. And in June, oh, and I just bought a new big piece of software and I'm gonna do an annual subscription, and because it's annual, I have to pay for it all upfront.

How profitable am I? Well, on a cash basis I'm a little bit losing money, right? And again, I'm looking at this short window of timeframe, but it's all over the place. Well, I was not profitable in April, and then I was way profitable in May. But was I really profitable? And herein lies the problem of just cash accounting. Like, you get these huge peaks and valleys due to the activity of the business, but was I really profitable?

14:51

Well, let's take these same activities and apply them with accrual actions. Now, in reality, a lot of these activities are gonna apply for way beyond this calendar period we're looking at. But I'm gonna apply those, and the period looks very different. So let's walk through that.

So in my cash example, my big activity in April was I bought some inventory. Well, that doesn't actually hit my profit and loss in April. It is going to go to the balance sheet. Oh, what's the balance sheet? We'll talk about that. It gets represented on the balance sheet, but my cost of goods sold was actually the value of the product that I sold in that month. Okay? So I was, you know, 30,000, 30% profitable. Okay? I should have looked at my numbers. If you're 30% profitable, or getting 30,000 on a hundred thousand in ecommerce, you're killing it. I just wrote down some numbers. You are a really great business if you have those level of margins.

16:05

Month two, well, I received, excuse me, $500,000 from my wholesale order, but they only sold 10% of that order. So they sold $50,000 worth of product, and then I made another $90,000 on my Shopify store. So I'm gonna apply $50,000 of that wholesale order in May, and then I have my cost of goods sold, and I used a 20% cost of goods sold, and my expenses are somewhat fixed. Hey, that was a really great month. Payment two on the inventory also went to the balance sheet. Okay, where was this balance sheet? Well, we'll get into that.

And then again, I had another, excuse me, another 10% of my wholesale order. I used simple math so we could all follow along, and also that it'd be easy for me to calculate. And then I had another $80,000 of Shopify sales. My cost of goods sold is approximately 20%. Oh, but this expense thing, that software that I bought was for a whole year. I only applied 2,000 of it in June, because that $24,000 worth of value is gonna be spread out over the 12 month period. So the remainder goes to this concept of a prepaid expense that sits on my balance sheet. So the balance sheet feels like a cheat code. Like, throw all this stuff over there. What the heck?

17:33

I have a raised hand from Sarah. Sarah, probably the easiest way for you, you could, if you want to, you could ask a question on the audio, or you could just throw it in the Q&A. So go ahead, ask your question, Sarah, and Kelley will monitor, but you've got your hand raised. Feel free to just dump the question in the question and answer. There's a little box at the bottom of Zoom, okay? So you can see here, I'll allow you to talk. Go ahead and ask your question.

18:13 Sarah

I just have a question. I'll put it in the Q&A.

18:16 Stephen Brown

Okay, that's great. Alright, so we'll go ahead and I'm gonna mute you again, Sarah. Ask your question. I'll try and answer it.

So it looks very different, right? And you're like, what the heck? That just feels like accounting black magic. This is stupid stuff that accountants do, that Wall Street does, to cheat us. Why do they do that, right? Well, fundamentally what we're doing is we're representing what happened in a business. And I think the way a lot of people struggle with accrual accounting is because, we know, we live with our personal lives, we are basically operating cash accounting. We don't get bills that we can pay three months later, right? And even when we do, we don't care. We just pay 'em. We don't work and get paid three months later, right?

19:10

All these kind of weird concepts don't really apply in personal life. But because of the dynamics of business, the ability to make a sale but get paid for it later, the ability to pay for software over an extended period of time. Now, that is something we can do as a consumer. We can buy annual subscriptions, but they're not big, right? Like when you're in a business, some of the software can add up. We don't buy big, big chunks of inventory that we're gonna sell later in our personal lives. And so cash accounting really works pretty well in your personal life, unless you're an accountant. I'm married to one, and she thinks we should accrue everything. I'll talk a little bit about that. Remind me to talk about that. You can go overboard on accrual, but there's certain things, particularly in ecommerce, that you really should be accruing to get a good pulse on your profitability month to month.

20:00

The other thing is, like I talked about, your business performance. If I wanted to say, hey, what is my cost of goods sold? I'm gonna be launching a series of blog articles on this topic. How much should I be spending on cost of goods sold? Is it a good amount? Is 20% cost of goods sold good? I'll tell you, it's great. But if I am doing cash accounting, I can't really tell that, because it's all over the place.

20:35

Okay, Sarah had a great question. Clarify this concept of the wholesale order. So just to explain this, Sarah, you had a really good question. So I get a purchase order, and my wholesaler's willing to be like, I'm gonna pay for $500,000 of product all upfront. Now, I actually talked to a friend who's also a new customer of ours about this. He is a master of wholesale, of retail, and he went out and he just signed up people, and they get these big purchase orders. But he is like, the actual sales of the product wasn't a million dollars, or in this case $500,000, all at once. It took a year or two years for them to consume that. And I was like, you didn't do revenue recognition.

21:18

So how would I do this? So I received the money, but like, how much is actually getting sold by that customer? 10% of the product is getting sold. And how would I track that? Well, let's say that the wholesale partner wanted you to ship all $500,000 worth of product at once. I would ask them for monthly reports. Can you just tell me how much product was sold every month, so I can record revenue in my books? Or maybe you will ship what they sell. You'd be able to look at your shipment and say, that's how much I sold. And we're gonna get into this in some specific examples. So Sarah, I'm hoping that worked. If you have further questions or clarification, go ahead and ask it again.

22:19

Uyi, I know we're friends. I don't know how to pronounce your name. We're like LinkedIn friends. I'm curious about sellers who do not have an inventory management system and do not have an effective way to track inventory, its interaction with COGS. How do we help sellers implement accrual accounting? Let me talk about that. We're gonna go into inventory. Inventory is the gnarliest of ecommerce accounting, and I'm gonna spend some time talking through how that works from an accrual basis, and I'll spend a little bit of time on how you would actually do that. Okay?

23:06 The three financial statements

Stephen Brown

Please ask questions if I'm losing you. We're getting into the deep end now. So accrual accounting really brings in the need for the three financial statements. There's the three financial statements: the profit and loss, which is also known as the income statement, or P&L for short, the balance sheet, and the cash flow statement, or statement of cash flows. Each of these do different things. So the profit and loss shows your revenues, your expenses over a period of time. So typically you're saying, what was my profit and loss for a month or a year?

23:45

So Sarah, thanks for the followup. I'm glad that my explanation worked. So yeah, how do you track sales to a wholesaler? That is really important if you decide to accrue really big sales like that. Okay, so I'm just going back to Sarah's question.

Alright, so profit and loss, what you're actually looking at is kind of the activity of the business. How much I sold, how much I spent. And on an accrual basis, I'm actually looking at how much I sold, but maybe I didn't receive the cash. A really good example of this is, like, I gave you a wholesale example, or like Amazon, right? Amazon has a deferred payout period. So I sell a bunch of product in June, but I don't get paid until July, because of the way that their payouts are. Shopify is usually a couple of business days. So whatever I sold at the end of the month maybe bleeds over to the next month.

24:30

The balance sheet represents the assets, what you possess. So that could be cash, that could be inventory, that could also be these more obscure accounting concepts like prepaid expenses. So I bought a piece of software, but I bought it for 12 months. Where does that purchase go? Well, it's an asset. Liabilities, what you owe. That's things like accounts payables, loans. That could be prepaid revenue. So I did this great big wholesale deal, yummy, $500,000, but I didn't actually sell the product. I still have to sell the product. They basically purchased the product in advance and they're gonna resell it. Well, where does it go? That becomes a liability of prepaid sale that I have to fulfill on. And then the other part is equity, the ownership value. Now there's an equation for balance sheets. Assets equals liabilities plus equity. For those who really want to nerd out on accounting.

25:37

The final one is the cash flow statement. Now, cash flow statements are really important when you're doing accrual accounting, because your profit and loss, again, if we go back, we'll see like, okay, this is what happened. I made 92,000, I should say, how good my math is on the fly, 94,000, 144,000. But if I were to look at what actually happened from cash, 'cause this is more or less what happened from cash, I actually lost $4,000. Where's my cash? Where did it go? Well, your cash flow statement is going to show you what's happened. It's gonna show you your cash from operations, from financing and from investment. And it's a little bit funky to understand, but it will allow you to understand how that money, where the cash is going.

26:28

And that's really important, because accrual profit and loss will really help you understand if you're performing well. But your cash flow statement's gonna tell you what's going on with cash, and your balance sheet's gonna help you understand, oh, am I running outta cash? Do I need to finance? Do I have things that I'm gonna owe? Oh, there's a whole bunch of things. And those are the type of things we're gonna drill into in the next two workshops, where I'm gonna have you run your report side by side with me and we'll walk through them.

27:07

Alright, so let's compare these three statements on a cash versus accrual. So profit and loss, cash, you basically are recording what happens in your bank accounts. So if all you're recording is, hey, if I got money in, that was probably revenue, or there's some other more advanced concepts, but let's just say money coming in is revenue, or refunds or something of that nature. And expenses, it's only recording when stuff goes out of there. So I bought a big chunk of inventory. Expense. Boom.

Accrual, you're recognizing revenue when it's earned and expenses when they're incurred, regardless of the cash movement. So in that wholesale example that I used, even though I got a big chunk of money from my wholesaler, I'm going to apply that in my profit and loss statement as that product gets sold. So what I would do in that situation is every month I would want some way to find out how much of that order was sold, and recognize that in my profit and loss statement. Same thing with the whole subscription thing. I'm gonna apply the expense monthly.

28:29

Now the balance sheet, when you're doing cash accounting, again, this is oversimplified, for those of you who are accountants, don't hate me. You're basically kind of tracking your bank balances and your owner's equity. Now that's not a hundred percent true, but that's kind of what ends up happening. In accrual accounting, you're adding interesting concepts like accounts receivable. So I invoiced my wholesaler, but they haven't paid me yet. Or they paid me, but I haven't sold the inventory that they paid me for. Or I bought inventory but I haven't sold the inventory. And I got a bill but I haven't paid the bill. Or I have a loan that I need to pay back over time. So all of these concepts, they end up showing up on the balance sheet. And there's this relationship between the movement of assets and liabilities, either on the balance sheet, and definitely on the profit and loss. When you do something on the profit and loss, it usually is also gonna be doing something on the balance sheet.

29:35

Cash flow statement is gonna more or less mirror your profit and loss, not a hundred percent, right? You could put money into the business and it would need to show up on the cash flow statement and the balance sheet. But if you're not putting money into the business or receiving investment, a cash based profit and loss statement would more or less show you what's going on with your cash. Until you put money into the business, until you take an investment, until you get a loan. And then it gets a little bit more complicated. And that's where like those things show up on the balance sheet, and those are going to adjust the cash flow statement. So the cash flow statement in accrual accounting is gonna take your net income, and then it's gonna adjust it for those other activities that are going on on the balance sheet.

30:35

Okay? This is complex stuff. I wish I had, you know, some of these things have like emojis or something. Oh, you can put in the chat if you're like, hey, thumbs up, I'm getting it. I'd love to get some feedback, 'cause this is deep stuff and I don't wanna lose you.

30:56 A real brand's books in QuickBooks Online

Stephen Brown

Okay, let's do a little show and tell, and I actually got signed out of QuickBooks. I'm gonna show you some real world data. Two years ago we bought an ecommerce direct to consumer brand, and it's our sandbox company. My partner and wife here at LedgerGurus, we partnered up with our marketing guy at the time who wanted to go do something. And we bought this business called Sole Toscana. If you like organic Italian skincare, it's really great. Mostly women buy it, but it's great for men too. So we bought this, and I'm gonna actually use real world data, not some sample data. This is because I own this, I can show my own data, which is one of the reasons we bought it.

31:48

So most people spend a lot of time on the profit and loss. And let me show you, like, we're gonna go much deeper later, but profit and loss, you've probably looked at a profit and loss. But I have my income, I have my cost of goods sold. This is all accrual based. And you see that I have this blanket statement, product COGS. We'll talk a little bit about how that works. And then I have a bunch of expenses.

Now, we're not accruing, I'm trying to think if we're accruing any expenses at this point. I don't believe we are, but we could. I can tell you we do accrue expenses at LedgerGurus. And I'll talk a little about, well, lemme talk about it. When do I accrue expenses? Let's just talk about it here. Accruing things takes time, which is money, or I have to go buy an app. Usually there are rules about what you can accrue, and by accrue, splitting it over time. So a software subscription is one of the best examples, and it's something that everybody runs into. At some point you realize, hey, I can save 20% if I pay all upfront. And if I have the cash to support that, awesome.

33:07

So after a couple years in business at LedgerGurus, we started buying annual subscriptions, and they're quite large. So we accrue, we kind of came up with a threshold. We said anything, I think we decided over a thousand dollars, we will accrue, or we will spread out that expense over 12 months. We're actually starting to talk about this. This business is not very big, as you can see. It's about 365. We'll probably do about 500,000, 550 this year. But we're starting to talk, hey, should we start buying annual subscriptions and try and get more profit out of the business? But we'll probably wanna accrue those over time, so that we have a good sense of profitability on a monthly basis.

33:53

On the other end of things, I have my balance sheet. So here is my balance sheet. You'll see I've got all sorts of bank accounts in here, including a lot of my holding accounts. Now you'd be like, man, Stephen, you have a lot of bank accounts. Well, we kind of got into Profit First, which I actually really like. Some people think it's overkill. I think it can be a really helpful tool. So we have dedicated accounts for profit and owner compensation and all that good stuff.

But then we have all our kind of holding accounts. Let me go to a different timeframe, because that period is not closed. So let's go to the end of last year. So holding accounts, you know, there was $11,000 at the end of December. You've got a lot of sales, there's $11,000 that Shopify owed us. And there was $2,000 in PayPal that we had not received in our bank accounts. They were just sitting there in these holding accounts.

34:57

The big thing that we have is prepaid inventory. I've also got this prepaid expense. Oh, I remember what it was. We had to pay a retainer for an attorney. So we put that down as a prepaid expense, because we weren't sure when we were gonna use it. And then I get down into some weird stuff. Goodwill, because we bought this business. There's this concept of goodwill. What the heck is goodwill? Well, for those who care to know, goodwill is the value of a business after all of its tangible assets. So we have this concept of goodwill that sits on our balance sheet, and it comes off and helps us with our taxes.

Accounts payable, that's pretty standard. We put bills in. That's what we owe. We have credit card balances, that's a liability. We have loans. We did an American Express line of credit. We have gift card liabilities. Here's gift cards that are out there that have not been redeemed. We have a loan, we loaned ourselves the business in the first year, because we had to put some cash in and we didn't want to do it as an equity transaction. And then we have a representation of equity. This is the cash that we put in to buy the business, right? So that's your balance sheet.

36:11

Statement of cash flows, people don't look at enough. Let's go and let's look at last year. And honestly, I don't look at it enough myself. I'll be the first one to admit it. So it was really rad. Thanks to tax treatment of goodwill, we operated at a loss. Yes. But was it a loss? Well, when we applied, there was a bunch of adjustments to our net income, and most of these are things you're gonna see on the balance sheet. The biggest benefit was taking that goodwill. And so we made all these adjustments, and really, operationally, we made $30,000 in that business, which made us really happy, 'cause the year before we did not. We lost a lot of money.

37:01

We also took some money in from a partner contribution. And then, let's see, what else? Oh, and then this was the cash at the beginning of the period. So overall, we increased the cash last year by 30,000 on top of the 34,000 that we had already, and that's what we had at the end of the year. So when I'm like, where'd my cash go? I can go to my statement of cash flows and find that out. And we're gonna dive into that in workshop three. Okay. If you guys are still with me, ask a question, whatever. Let's jump back in.

37:45

So, Uyi, go ahead, hit me up with your question. Oh, I wanted to say, Uyi, how do you pronounce your name? Just so I don't murder it.

37:55 Uyi

Uyi.

Stephen Brown

Uyi, okay. Thank you.

Uyi

Yes, yes. And you cannot get it wrong, because the initials of my name spells U and E.

Stephen Brown

Ah, you're safe.

Uyi

Yes. So I wanted to say thanks for showing this, the real life samples, so that we can follow.

38:21 Stephen Brown

Okay, no problem. Any other questions? No? Okay, awesome. Yeah, and like I said, we're gonna dive into this much more deeply in a couple weeks, but I wanted to show, this is a teaser for workshop two and three. Let's get back into accrual, if I can get my PowerPoint to load. Hold on one second. My PowerPoint decided to disappear on me. Give me one second. It doesn't wanna load. Okay, I'm gonna restart my PowerPoint real quick.

39:06 Three principles and what counts as revenue

Stephen Brown

Okay, so we've kind of talked about the financial statements. I've showed you the financial statements and how we structure them in this example. Let's talk through a little bit of accrual accounting, how this works. So where were we? We left off here.

So there's these principles. When you're looking at these statements, there's some principles that you really need to understand. They'll help you understand what you're looking at. There's actually a couple more, and if we get into things like generally accepted accounting principles, GAAP, there's a whole bunch of rules. But GAAP really looks at accrual accounting at a much more granular level. I'm gonna talk about three really critical principles that you need to follow: the revenue recognition principle, the matching principle and the expense recognition principle.

39:50

So revenue recognition. Revenue is recorded when earned, even if payment hasn't been received. So in the example of our wholesale, we don't record it until we've actually sold that product. The matching principle would be, expenses are recorded in the same period as they relate to revenues. For example, your cost of goods, your fulfillment, your merchant fees that are all associated to a sale. And the last one is expense recognition. Expenses are recorded when they happen, even if they were paid for later, or, in my example of the subscription, earlier.

40:25

And Sarah has another question. So for an expense like a monthly gas electric utility, do you match the expense to the period covered by the bill, or just enter the bill when you get it and that date becomes the date you use? That's a great question, Sarah. So a bill, usually when you put in a bill, there's two dates that you're putting in there. There is the date of the bill, and then there's the date that the bill's due. And usually what's gonna happen in accrual accounting is that bill is gonna apply based on the date of the bill.

41:01

So one of the really annoying things that happens to all of us is when you have a vendor who sends you a bill really late, from like three months ago, and you're like, hey, I thought I was done with January. I thought I was done with 2023. What's this bill? I won't name names. I have a vendor who always is really slow on their billing, and it kills us at the beginning of the year when we're like, how did we do? Where's that final bill? So that's how bills work. Typically when you put a bill into something like a QuickBooks, the date of the bill is gonna determine the period that it applies in. The due date is just when the cash needs to go out and close that bill.

41:44

And I'm gonna talk a little bit about bills. Now, when you get into something like a monthly subscription, that's a little bit different. But accrual accounting as it applies to like utility bills, that's how it works. And it's really annoying when somebody bills you late, because if you have a bill from a couple months ago, that expense is gonna show up a couple months ago, even though you're gonna pay it earlier. So, great question. Keep the good questions coming. Don't let Sarah be the only one. I should give gold stars to the best questions.

42:17

Okay, let's walk through some examples. I'm gonna take you back to accounting school, and then I'm gonna have a really fun example. So if you need a wake up call, it's coming on the next slide. Let's do revenue recognition. How does this work? I'm gonna walk through this really slowly. So I invoice my wholesale customer for $500,000 in April. I didn't show that in my example, but I'm gonna show it here. I was kind of just showing what happened from a cash basis.

So I send them out an invoice. Well, with that invoice, the thing about accrual accounting is this concept of double entry. I didn't really talk about it. I should have. Double entry accounting, for those of you who don't know, it was invented by a monk in Italy. Luca [unclear], I think was his name. And the idea is I put something down in two places. And usually what happens, you're either putting them down in two places on the balance sheet, or you're putting them one place on the balance sheet and one place on the profit and loss.

43:17

So when I send out an invoice, my accounts receivable, what I'm owed, is going to increase by $500,000. But did I sell anything? No, I didn't. I basically am earning some prepaid revenue. So I'm going to apply $500,000 to prepaid revenue. Apologies, PowerPoint on Mac doesn't love me. And those balance out. So the thing about the balance sheet is the assets should always balance out with the liabilities and the equity. So if you add something on one side, you have to add it on the other. And that's what's happening here.

44:01

Now, come around May, my wholesale customer paid me the full $500,000, right? Awesome. So my accounts receivable decreases. I got my cash and it goes into my bank account. This is on the same side of that equation. It's an asset. So accounts receivable is an asset, cash or bank accounts are an asset. So one goes up, one goes down. And that affects my cash flow. It shows that I increased cash due to AR. And then in May, my partner, I check in with him and say, hey, how much did you sell? They're like, hey, we sold $50,000 worth of product. Awesome. So I'm gonna apply $50,000 worth of revenue, and I'm gonna take this funky liability account, prepaid revenue, I'm going to decrease it by $50,000.

44:53

I'm missing something. I just realized, this prepaid revenue. Okay, my accountants out there, I'm just thinking, I realized I think I missed something. Anyhow, so that's kinda how it's worked. Sarah's asking a question around expenses. We'll get in, I'm gonna answer your question here in a bit. I think I'm right, but I feel like I'm missing something. I did this fast and furious. Essentially, that's what's going on across my financial statements. Now, the reason I'm scratching my head is I'm like, I decreased revenue $50,000 on my balance sheet. I feel like there's something else I'm missing. Okay? Those accountants who are paying attention, you can correct me. If you're not paying attention, you missed out.

45:48

Let's do a kind of a crazy example. This is the Shopify finance summary. What is the revenue? So I'm gonna ask you a question. This is kind of accrual accounting, but it's also just understanding what the heck's going on. So I'm gonna give you a choice of four questions. If I were to post purely off of Shopify's, this is the finance summary report. We always get this question: why does your revenue number not match the number in QuickBooks? Why does the Shopify number not match? I'll tell you, there's more than this example, but I want you to just do a calculation here. And I've just launched a poll. I'm gonna give you four options.

46:38

What would be considered my income in QuickBooks? Would it be my gross sales number of 48,000? Would it be my net sales number of $40,957? Would it be my total sales of 42,224? Or would it be none of the above, 41,790? I've got a couple questions. I'm gonna give you like 30 seconds to answer, so maybe a little bit more if you're trying to figure things out. I will just tell you, as a cheat code, the last answer is the total sales minus taxes.

47:23

So which one of these do you think should be income on a profit and loss statement? And it looks like we have a pretty good collection of answers here. 10 more seconds. 9, 8, 7, 6. I wanna get half of you answering. Five. One more answer. 4, 3, 2. Alright, I got somebody else to answer. Okay? The right answer, half of you got it. It was total sales, excuse me, it was total sales minus taxes.

48:11

So let me walk through and talk why this is, and then I'll show you in my profit and loss how this translates. Gross sales. We actually will put gross sales on our profit and loss statement, because then we can do things like measure the percentage of discounts by month. And so the temptation is to say, hey, net sales is revenue. Oh, but what about this shipping income? I charged for some shipping. Is that income? Well, actually it is. So I should have had one more answer. It should be like 48,000 something something, these two together. Well, that is the answer that I had, the answer four.

48:54

Shopify is really dumb. They do this stupid thing where they include money collected for taxes as sales. It's not a sale. It's actually a liability that you owe to the government. So this is one of the things that all of us accountants hate about Shopify, 'cause they'll be like, what happened there?

Now, the other thing why the number might be different, if you're doing thorough accrual accounting, is maybe you sold but didn't fulfill. And some customers care enough to say, let's only apply what we fulfilled in that month. And so then we'll have to look at the sales and say, okay, you sold this many, but you actually fulfilled this many. And so that changes the number a little bit. I wouldn't encourage that unless it's really, really important to you, because Shopify payouts happen so quickly that you're gonna save a lot of money by just recognizing that revenue in that time period.

49:53

But there are rules around generally accepted accounting principles that say actual sales should be something that you actually fulfill on, everything else is a prepaid liability, da dah dah dah dah. I'm a nerd, right? That's all I hear when I hear my accountants say that. Sorry if you're an accountant, I didn't mean to offend you. But I'm like, is it material? As in, is it a significant amount that it's worth all that effort to recognize it? Or are we talking about like, you know, one 30th of revenue? Eh, that's fine. I just lost you or offended you. I apologize for both.

50:26

Alright, let me show you how this shows up in our profit and loss. So let me take one of my closed periods here. I have not closed August. And some people are like, why does it take so long to get financials? Well, I gotta wait for all those reports to generate so I can do that. So you can see here that I took, and we've got our gross sales, and then we have our discounts and returns, and then I have my shipping income, and then I have my total income.

51:04

So where did my sales tax go? Well, sales tax, lemme pull that out here on the balance sheet. Let me find that bad boy. Let me go back to a closed period. We'll go back to last quarter. That should be a liability, sales tax liability. Here we go. So I have right here $572 that I've collected that I have to pay the government at some point. So boom. Paresh, will there be a recording? Yes, there will be a recording, and you will be able to watch from the beginning. So thank you for asking that. And Sarah, I have not ignored your question, but I'm gonna hit it here in a minute, when we get into the expenses.

52:01

So again, here is the example of taking my Shopify sales and how we have translated 'em for this particular business into my QuickBooks. There's a lot more we could do, right? Like I said, if I wanted to be really picky and say I'm only gonna recognize revenue when it's fulfilled, there's a whole nother set of work that we have to go through. But what Brittany and I see eye to eye on is, is it material? Is it significant enough that it misrepresents what's going on?

Uyi, why we have a sales tax clearing account? That's a good question. I think what we end up doing here is, it looks like we're applying, when we pay out, we clear it there. So basically that's what I'm doing there. You'd have to ask my sales tax team how that workflow works. I'm not as familiar with it. Or sorry, Uyi, sorry I keep mispronouncing your name. But you know me, hit me up on LinkedIn. I can probably give you an answer. We're friends on LinkedIn.

53:10 Matching, expenses, inventory, and next steps

Stephen Brown

Okay, let's get back to it. So revenue recognition. The next one is the matching principle. And this primarily shows up in your profit and loss statement. And so if I sold a hundred thousand dollars of wholesale product in June, and again, this is a little bit different than my example, but I didn't receive payment until July, I'm still gonna apply the sales in June. A better example of this would be like Amazon. Hey, I sold a hundred thousand dollars of that product, but I didn't receive all the cash until, you know, a more significant amount till later. But when I look at Seller Central, it says, this is how much I sold.

54:03

Cost of goods sold, I'm gonna apply the value of what was sold. So the value is, and we'll get into inventory here in a minute, the inventory gets really gnarly. Not what inventory I purchased, but the value of what I sold. So if I have the cost of my widgets, and I knew how much I sold, and I multiply that and add it up, that will give me my cost of goods sold. Another example would be fulfillment. We get billed from our 3PL, it's actually pretty awesome, the following month, and we don't have to pay till the month after that. So they fulfilled for me in June. They bill me in July, and I don't have to pay them till August. It's amazing. But that bill, it's applied to June, when sales were fulfilled.

54:54

Lemme come to your question, Sarah. So utility bill, there's a third date, or set of dates. The bill covers a certain period, that's when the expense was incurred, but you get the bill date. So Sarah says the range of when the utilities were billed, the middle of May to the middle of June, and I got billed on the 25th. This is a good one for the matching principle. And it's due in July. So should we accrue that expense into June? Hmm. Great question. Or do I just use the July 25th date?

55:34

Okay, there's a fourth principle that I didn't put in here, but I've talked about it already. Materiality. Is it significant enough that it's worth the time to accrue it? So if I was really, I'm gonna use a, I don't know how to, anal retentive, sorry, I can't think of a better word. And I'm like, oh, those utilities were spread out over two periods. I've gotta break down that bill. But how big is that bill in the grand scheme of your expenses? The other thing you have to think about is cost benefit, right? A utility bill is relatively small, and even if it's a decent size, like, is it worth all the effort to break that cost down? So materiality, reasonability, right? Is it reasonable? There's a concept of reasonability for recognizing expenses. This is another principle that I didn't put in there, but it's up there. Is it reasonable to recognize the expenses all in one timeframe, even though it covered two? Sure. Because the cost of doing the accounting's not worth it.

56:42

I'll give you some examples from my corporate experience, 'cause I spent a lot of time in corporate America. We've got the scars and the wounds to show it. And then I'm gonna tell you about some of the things we've experienced with some of our customers, where I feel like they've gone too far with the accrual accounting. So before LedgerGurus, I worked three fourths of the time in larger companies. They were either public or private equity. One was a big stint in a Fortune 500. And then I spent some time in some startups.

57:21

Let me tell you things that they don't accrue. Expense reports. I had coworkers that would submit expense reports like months later. They're not usually going back and posting those in the future. That's where you have policies that say, hey, post these later. So that's probably one of the best examples of accrual stuff where it's like, oh, I could go and accrue this, but it's gonna be really expensive to do. Same example, we had a customer, they would say, I bought flights in March for a trip that I'm gonna go and do in June. Do I go in and jump in and do those later? No. You know, just apply 'em when you spend them.

58:11

Okay. So, and I'm gonna wrap this up. I realize we're almost at the end. I've got a couple more slides, so if you have to drop off, feel free to watch the rest of this. We'll send out the recording. Yeah, and Sarah, you're right, it is nuts to go that far. And you can go too far, and don't.

Okay, let's finish out these concepts, and then I'm gonna point you to the next step. Annual software subscription, we're gonna go faster through this, we've talked a lot about this. So I receive a bill for 24,000. My accounts payable goes up. My prepaid expenses also go up. So I have this asset, prepaid expenses. I pay the full bill, my accounts payable goes down, my bank account goes down, and that's gonna reflect in my cash flow statement. And then I use a full month of software. So I'm gonna apply one twelfth of that purchase, for $2,000, to my profit and loss, and my prepaid expenses go down.

59:13

Okay? Inventory's gnarly. If you gotta drop off, watch the recording. I order $500,000 of inventory. [unclear] Nothing happens on my statements when I order. That's a purchase order. Those don't actually hit the financial statements. Manufacturer sends me a bill for 250,000 to start the order in April. So I decrease some cash and I increase an asset, prepaid inventory. See a decrease in cash on my cash flow statement. Manufacturer sends the final bill a couple months later. I lose more cash and I increase my prepaid inventory. Cash flow, cash goes down.

1:00:00

July, the order arrives. I pay $10,000 for shipping. My bank account goes down, and, my order's done, yay, I'm gonna move that prepaid inventory into an inventory account. That also includes the value of shipping, landed costs. And so I decreased the amount of prepaid inventory. Now in July, I also sell some product. Oops. And I'm showing, hey, I got more cash from sales, and I also decreased my inventory by $20,000, because that was my cost of goods sold. So inventory's super, super tricky. I could spend a whole hour, probably five hours, just on inventory.

1:00:42

Okay, these are the concepts. What are we gonna do with these concepts when you come back? And I hope you really will. I'm gonna tell you how I use profit and loss statements to make better decisions. What I've tried to give you is a foundation of how profit and loss and balance sheets and cash flow statements work, so I can show you how I analyze them when I'm working with my customers or my own businesses to understand and make better decisions.

Two links I'm gonna send you. I'm gonna send you a link to these webinars. So if you haven't registered and you'd like to, please join the next webinar. It's gonna be a lot different. We're gonna spend more time in QuickBooks running reports, and I'll talk through how I look at that data. The other thing I'm gonna say, if you need help with this, please reach out. If you have any other questions, I'll stay on as long as you want to answer those questions. We will send out the recording. And I hope that you'll join me for the next webinars, because what we're really gonna do is use this data to be smarter with our businesses. Okay?

1:01:54

Uyi, with the fluctuation in shipping, by air, regular, and in view of these fluctuations, would there be any situation where a seller should not include inventory in landed costs? So this is very, an accountant, no. I would say you should always include inventory in landed costs. You should always include shipping in landed costs. Your inventory value will fluctuate if you're looking at the unit costs, right? The unit economics of what you paid for.

So inventory value, we look at it with three components. The cost of manufacturing, the cost of shipping the inventory into my warehouse, the cost of any duties and import fees, et cetera, the cost of packaging related to that product. All of those get wrapped up into a single cost that gets allocated to the unit economics that I can use to calculate my cost of goods sold.

1:03:00

Now, Uyi asked me a good question. What if somebody doesn't go through that exercise of tracking all those costs, uses an inventory management tool? It's hard. Inventory accounting is very gnarly. It's expensive one way or the other. The seller either have to spend a lot of time, or we, the accountant, have to spend a lot of time. Usually there's a little bit of both. There's tools that help that. But good inventory accounting is an investment. But I would include all costs related to getting that inventory into the warehouse into my inventory value, which then comes out of that into cost of goods sold as I sell those products.

Any other questions before we wrap up here? But otherwise, we'll wrap things up. And with that, have a good day.