146: Accrual Accounting Part 4: The Matching Principle and Expense Recognition

Welcome to DSO Secrets. I know what it's like to be an entrepreneur in the dental industry. I've had my ups and downs just like you. There's so much opportunity to be excited about, but so few resources to get answers. From here on DSO Secrets, we get you those answers so you can change the lives you're meant to bless and achieve your personal success.

When I was working as an associate right out of school, I never imagined I could own these many practices with this amount of support. So thank you.

You have helped build my marketing mind

to a whole new level. You have this natural talent, this unique ability. Hello and welcome to another episode of DSO Secrets. I am Ken Kaufman, your host today and so excited to be back. Finally, we have done three of five part series of episodes on accrual accounting and how to make the change, how to make the leap and why you need to make the leap. In fact, episode one was about the why and then the next two were about revenue recognition and how that impacts the income statement and how that impacts your balance sheet. Today we're finally to episode four. But before I tell you about that, episode five will be a wrap up where we summarize, pull it all together for you and send you off into that accrual world. So today in episode four, and I need to welcome back Holly Williams, CFO at Rodeo Dental. Holly, thanks again for joining here. Episode 4.

Thanks for having me.

And we do need to recognize Mike William, or Mike, Sorry, I did call him Mike Williams on the last episode and that was a complete blunder. Mike Yates was with us for the first three episodes, but unfortunately family emergency has him away. Holly and I decided this content was so important, we just power through and we'll get Mike back for episode number five. And I think, Holly, we'll just have him do all the talking. That would probably be the best, right?

Yeah, we can do that.

Perfect. All right, so Holly, we're going to jump in today to the expense side. A lot of effort was around the revenue. And how do you recognize your revenue properly? We're going to need to now jump to the expense side of things. And in dentistry, this tends to be the simpler, easier area in terms of converting to accrual. In fact, many organizations will convert first their expenses to accrual and then, and then bring the revenue over if, if they're trying to stage it or take their time with getting it figured out. But why don't you, Holly, just go back and reset for us the concept of the matching principle and how that applies to expense Recognition on our income statement.

Well, you know, accrual accounting is about matching your revenue and your expenses together. And revenue, we talk a lot about making sure that you're trying to recognize what you actually think you're going to earn based on the data service. And your expenses are equally as important. And so you may prepay for items. Maybe you have some computer service contracts that you pay quarterly. And so once every three months you're paying a large sum of money. And if you're just on a cash basis, those three months or those quarter months are going to be very heavily impacted by that expensive service contract. So in accrual accounting, you would actually recognize that over, you know, you would divide that out and recognize a portion of that each month that belongs in those months. Same thing with your supplies. I mean, you have to make a decision if it's, you know, a large enough number for you to have an inventory balance and so that you can really look at, you know, maybe if I pre order a bunch of items, you know, I can save some money. And then now I have a large amount of supplies on hand and as I use them, I recognize those expenses. So it matches your, what you're spending to take care of the patients with the revenue that you're recognizing.

Yeah, that's a great overview. I really appreciate you taking that on. And the interesting thing about this is when you're cash basis, you're literally just recognizing when the money leaves your bank account. And so if you're paying a year's worth of a subscription for say a software service or insurance, you're paying a quarter's worth of Internet service, you're paying some amounts ahead in this manner, it makes your income statement very lumpy. And when we talk about accuracy, first of all, getting your revenue recognition right is so critical. But expenses are so critical too because they create this lumpiness and, and all of a sudden you say, hey, wait, my practices are, they're 18% profitable. No, they're 24% profitable. No, they're 13% profitable. That doesn't look stable. That doesn't look like you really are a good operator of the business. When you get your expenses all dialed in to an accrual recognition, meaning when they were incurred, not when you paid for them. And to the degree it needs to be spread out over 12 months because it is an annual insurance contract that you paid or a software subscript that you paid, it's so critical because it drives accuracy and it helps you see very clearly what your margin is. And it's not bouncing all around. And Holly, I have this great example from my very first CFO gig, by the way. I was way over promoted, way under qualified when I went into this role. And I was fascinated because I walked in and I brought the financial statements. The controller had just finished, and I was new. I was still learning what was going on and what was in all the accounts and how it all worked. I sat down and I passed. There were seven of us, so I had seven copies and passed them around to everybody around the table. And immediately there were all these excuses about why the financial statements were wrong. They were coming in left and right. Well, no, it was a construction company. Customer didn't pay us this month. So that's why this happened. And no, this happened over here. And it was all about timing. And I watched this debate go back and forth and I said, okay, I remember that accounting class. I remember these other companies I've been in. I can fix this. And so my goal was, give me a month, let me go back and see if I can clean this up. It took several months before we started to get things to an accrual basis. But all of a sudden what happened was, and this is the power of converting to accrual. Our discussions went from debating about why the financials were wrong to acknowledging that they were right now understanding our business, and now actually having a great conversation about what can we do to improve, how should we think about growth. Any reaction to that, Holly?

No, I think that's exactly right. Anytime you can actually spend your conversation around the P and L, improving your business is a good conversation. Maybe you didn't realize that because you have quarterly contracts that are being paid. You know, maybe they're being paid once every three months, but in different months, you didn't realize you were really spending that much to support your operations on a monthly basis. Or, you know, on the flip side of it too, when you're. We've talked a lot about already about prepaying for services and making sure that you are spreading that out over the proper months. You also have to think about the stuff that you've. You've spent but you haven't paid for yet. And that's mostly around your labor and benefits that you're promising to your people, paid time off, those kind of things. And so you are incurring a liability to your staff when you're, you know, when you have them come in. And you just need to make sure that you're properly putting that in the period where you, where you produce the revenue and because you need to be able to really accurately watch your percentage of labor dollars against the revenue that you're actually producing.

Spot on. You're taking us right to the next part here. I think what we want to do is now jump into some detail on each of these. And when I think about the expenses, Ollie, I always think about the balance sheet because expenses are hitting all over in your income statement. But when I look at the balance sheet, there are going to be some accounts and on the balance sheet that are the only reason they exist is to allow you to be accrual basis. Let's and let's start, Holly, by talking about the contra revenue, contra assets asset accounts. We've talked about this before on the revenue side, but you are going to have some balance sheet accounts underneath your accounts receivable because your accounts receivable is part of revenue recognition. And how much, how much of the services provided just haven't been collected yet. So it's sitting in that bucket. But you have these contra AR accounts that are reducing that balance by what insurance do you think, or you know, what insurance payers aren't going to end up paying because of, you know, either you did services outside of their contract or something like that, and then are patients going to pay or not? Do you want to maybe take just a quick second and reset that for the listeners on this being on the balance sheet and why it's important for it to be there, these contra AR accounts.

So the AR accounts and the balance sheet I think we've talked about before, the balance sheet is a picture of what you have and what you owe and your income statement is the activity in between the dates on the balance sheet. And so your AR is kind of similar. It's going to look very similar to your revenue side. You have your gross production minus the contractual adjustments that you think are going to happen, minus the bad debt or you know, the amount that you don't think you're going to be able to collect from patients, that's on the, on the P and L side. But the accumulation of those accounts in our world, we call it the roll forward. You roll it forward from one month to another is on your balance sheet. So your gross production is going to be your gross AR account. And then you collect money, you make adjustments, you write off accounts that all gets affected there. But what's still left to be collected and still left to be adjusted or written off, it's going to be those contrast accounts on your balance sheet. So it's just, it's bringing that net AR number down to equal the accumulation of net revenue that you've recognized that you haven't yet collected.

Perfect. That's perfect. Description. I think that was textbook, actually.

Description.

So when we then go further down the other things that are considered assets, because your balance sheet starts with assets, and then you get your liabilities and then you get your shareholder equity or equity section, one of the ones that'll show up first is inventory. So walk us through what inventory means and why it's sitting on the balance sheet.

Well, and actually, if you, if you don't mind, I want to step back a little bit because if the listeners aren't familiar with actually paying attention to their balance sheet, because in cash accounting, you typically don't. Your balance sheet is ordered in liquidity, you know, so your top accounts are going to be your cash accounts. And so that's going to be, you know, it's how fast are the items below that and they're ordered in, you know, speed of liquidity. Are they going to turn into cash? So you have your cash, which is already cash, every accounts receivable, which are going to be collected and turned into cash. So that's next. And then inventory is something that you're going to quickly turn into cash because you're going to use it as you provide service, which is going to then turn into AR and then turn into cash. So that's how it is typically ordered.

Great.

So, you know, so when you're looking at it, you know your, your inventory is usually next right underneath your ar. And those are the things that you purchase from your suppliers to be able to provide the services to your patients. And so you, you have your staff, you have your, you know, your facility, and you have all of your fixed assets and your equipment, but you still need those supplies. So if your supply inventory is large enough and it makes sense for you to do a count every month and kind of know how much you have on hand, if you typically want to keep $100,000 on hand, then, you know, you just count that and you, you know, make sure that you're not going higher or lower. If you're not tracking your inventory, you can very quickly run into a situation where you're ordering things without paying attention to what you actually have in your office. And so you might surprise yourself if you go count and pull everything out of the cabinets and drawers and closets and like, wow, I could almost go a whole month without buying anything else. So being disciplined in taking inventories in your office is really helpful for that reason. It just manages your costs, spend again.

Because the alternative here is if you're not booking it as inventory, which any given day, you. You've got to have inventory on the shelf because those patients are coming in, you have those supplies. There's got to be something there. But you may pay a bill and then wait for three more months until you pay the next one and until they're calling you and upset and saying, hey, pay for your inventory and what's going on here? And then all of a sudden that money goes out and it becomes a really interesting challenge to get the financial statements right. You can't. You shouldn't be counting the expense this month if you're going to use the inventory the next month. Right. And it is kind of a month by month opportunity to adjust or some. There are some companies that have gotten it so dialed in and they're comfortable that maybe they adjust it quarterly or annually. Sometimes you do an actual physical count and assign the value. In dentistry, I don't know, Holly. My experience has been physical count is hard because everything that dentists work with is like that, is that small because it's going in the mouth and it's hard. It's hard to count all those things. And. And there are big bottles of things and you're like, well, is that a third empty? Is that a half empty? So, yeah. Any experience or thoughts on how you

value it is very difficult because, I mean, I kind of view that as commodity based. I mean, there are things that you're just going to use, and it's a very difficult predicament. But I will say I came from the oncology space as well, that nurses and probably VAs are the same. I'm not gonna say for sure, but they like to hoard things. Like, they like to just have a lot of everything on hand so that they don't run out. Because, I mean, it is a very bad conversation to have with a patient and a doctor. Oh, we'd love to do the service for you, but we don't have the service supplies that we need. That's the conversation you don't need to have. And so I think, you know, we, we watch our inventory as a percentage of our change in inventory as a percentage of revenue. I really don't have a. I think everyone kind of has to come to what works best for their own practice. Counting by estimation is, you know, better than not counting at all. You know, if you have half a bottle of something and you know you're going to need more. I mean, it's better than nothing at all. But to properly have inventory on your books, you do need to be able to recognize or reconcile that to actually what you have on hand.

Yeah, and I'll oversimplify the way that we think about it. Inside our organization, we actually had a couple of years where we did physical counts, and it was horrendous. It was so difficult. Location spread all over. This office chose to not count certain things, and this office double counted other things. And so it was confusing and hard to get accurate. But at the end of the day, we got really comfortable that we could see how much inventory. Meaning is it one month, two month, three month, how many months of inventory are on hand relative to the size of the practice? And so we could see if it's doing this much revenue than it needs probably at any given moment about this inventory. So we're able to kind of do that study. We've gotten to a comfort level. At some point down the road, maybe we'll do another physical count. But right now it's manageable and it's not a huge number for the. For the most part, even if you're off a little bit, it's immaterial relative to what you're looking at in your operating income.

But you would also learn, like, if you just say that this is the par inventory level that I'm going to keep at this office based on their volume, and you see orders coming in that are, you know, all of a sudden your expense load is getting really heavy. You're going to, you know, go into that office and say, okay, you know, you guys are over ordering because the revenue is not going up, but your ordering is. And so you're either, you know, accumulating a bunch of inventory, and that's when you would have someone from your procurement team go in and look like, open all the cabinets and open all the doors. And, you know, it is really easy for people to forget. I mean, sometimes if you have some staff members that are receiving boxes of supplies and they set them off in the supply room and they don't ever open them, and then another staff member comes behind them in orders, I mean, you could. You could really get yourself in a situation where you have items that are going to expire, and you know that that's very expensive for your practice to do.

Yeah, great point, Holly. All right, so moving from inventory, I think next on your list in terms of order of turning to cash, are probably prepaids, or do you have something ahead of that?

Prepaids. And that one actually is Kind of opposite. You've already spent the cash, but it's going to come across your P and L as an expense. And so that would be your insurance policy. That's a 12 month policy, but you go ahead and pay it up front because you get a big discount or you don't have to pay the finance fee. So you go ahead and pay it out. But it does convert to expenses over the next 12 month period or 3 months or however long you prepaid.

Yeah, so if my policy is, I'm just going to use an easy number, $12,000, and I'm paying for the whole year. What you do is you take that amount and you allow $1,000 to be recognized in that first month of the policy period. And then you put the 11 other 11 months on the balance sheet in this prepaid category and then you just release $1,000 each month throughout the year. And then you don't have a big $12,000 hit. It's spread out because you're also, it's also the true recognition of when you're utilizing the quote unquote service here. In this case, the insurance is you're using it or having the protection of it all 12 months. And so you should equally represent it throughout the, throughout the year.

So back to the theory of this is what you have. So if you, if you think about Today, you know, March 31, April 30, whatever day it is, you know that you're sitting down and looking at your balance sheet and you were to not operate any further. Now these are not the fair value of the items that are on your balance sheet. You know, but you're going to collect your ar, it's going to continue to come in your inventory. You probably are not going to be able to sell for what you have value just because it's, you know, if it's a fire sale but you're prepaid, you probably will get a credit from the insurance broker and you know, you may pay $12,000 and you cancel it in month three, you're going to get $9,000 back. So it will come back to you. And so it's again, you have that as a credit with that vendor that you've put prepaid. And that's, you know, another reason that it's up high on the current asset section.

Awesome. Anything else in current assets in dentistry? I think that's mostly it pretty much. What about, what about a deposit on, on with a landlord when, when I, I sign a lease and they say, hey, you need to put first Month's rent on deposit. Where does that go?

So that's in your long term assets, I mean, down in your deposits. Because that's not something you're going to get back until you vacate the property, which, you know, I'm assuming you're going to sign along, you know, 5, 10, 15 year lease.

But to be clear, if you're not on accrual, you're expensing that. But technically you shouldn't.

Right.

It should sit there on the balance sheet until you come to the end of your lease. And maybe you don't get it back, but the landlord uses it to pay your last month's rent. That's still money that you're saving yourself. It is still a true asset.

Right, right. It is an asset. You get to use it in the future.

Awesome. All right. Anything else stick out on the asset side before we jump to liabilities?

Well, I mean, we talked about fixed assets, I think a little bit too. I mean, if you're going to spend several hundred thousand, three, four or five hundred thousand dollars to outfit your office, you know, those are assets that go onto your balance sheet. You depreciate them over time. And so you expense those as you use them. Of course, you know, the life that you choose for those assets, if you want to think that they're going to last you 10 years, 15 years, those are all decisions that you have to make. But you expense it as you, as you use those assets. And it really does, again, give you a really good clarity into what it costs you to run your business, really.

And you do the best you can to spread it out over what you think the lifetime of it will be.

And that's different than IRS rules. I mean, we're talking about the business and what, what, how long you're going to be able to use those assets.

Yeah, you're right, because I think a lot of our listeners are still in the mindset of, oh, if I have fixed assets, I can use section 179, I can accelerate the depreciation and get all that expense to offset income and save myself taxes this year. That's one thing this is actually saying, hey, this asset is going to last for 10 years and I'm going to take every year, I'm going to break it into 12 pieces and I'm going to recognize it monthly. And I don't know if you'll appreciate this, Holly, but when I have had conversations with doctors about what fixed assets are and how they work and how we depreciate them, I take A picture of the outside of their office. And I say, okay, you're a patient walking into that office. Is it fair, just for the patients on that first day open, that all the expense gets recognized? And even though maybe you only saw five or 10 or 20 patients that day, no way. That beautiful sign. Look at how well finished out it is. And then I take a picture from the inside and say, look how beautiful it is on the inside. And all this beautiful equipment, you don't just expense that on your income statement day one, you book it as a fixed asset and you spread it out over what you think the reasonable lifetime of those assets are. And then. And that is very much an accrual activity that allows you to see what's really happening in the business.

Right. And there's so many different ways to look at your business from a finance perspective. But what we're tackling is your GAAP financial statements that are going to be auditable, and you will be able to show the profitability of your business as it's running today. You made an investment in that business when you purchase those fixed assets and ROI calculation of how fast can you return, you'll get that money returned to you, and is a completely different conversation. And so burdening yourself with all those assets at the very beginning and then counting how many patients it takes you to get all your money back would be an ROI calculation. But what we're talking about is the income statement on the operations of the business that an opinion can be given in an audit.

Yeah, yeah, that's right. And if the air conditioner breaks and you have to spend $15,000 to replace the big, huge unit sitting on top of your building, you don't show a $15,000 expense on your operating P and L, because that's not part of operating the business.

Right.

You put it on your balance sheet and then you depreciate it out over, I don't know, in Texas, what are air conditioners lasting, like two years at this point? Three years, hopefully.

Right, that's true. That is true. That it's going to provide a future benefit for more than one year.

Yeah.

You know, and, you know, everybody has to have their own policy. I mean, you know, I think, okay, I don't want to quote IRS rules because. But I think, you know, somewhere around $2,500, you have to capitalize it that, you know, kind of thing. But you can. You can talk to your accountant and have, you know, policies and rules set up. I mean, you don't want to capitalize every little desk and every trash can and all of those things, even though they're going to last you for many, many years, they're just not the, you know, large enough to do that.

And even computers at this point. Right. Because cost is so low. And about every three years, you're burning them out.

The other thing, too, is you don't want to. When you're looking at that capitalization policy, you really want to look at the individual items. And so you wouldn't. Like, take, say, for instance, you're setting up the desk for 10 people, and you're buying computers for 10 and desks for 10. And, you know, all of the needed office equipment for those 10 people that invoice is going to be big enough that you. You're going to be tempted to capitalize it. But if you look at the individual items, they're not. So there's a whole nother conversation to have with your accountants. But, you know, I'm talking about your chairs, your X ray machine. I mean, you know, just all of the big stuff that you have in your office that is a fixed asset that does cost you a lot of money. You don't want to burden your first month P and L with. And you know, and that does. And then because it falsely increase, it falsely inflates the preview the P and L's following. And so it's not like ripping off a band aid and saying, oh, okay, well, my first month's going to be bad anyway, so I'm going to throw it all on there. But then you're falsely overstating your earnings for five, six, seven, eight years out. Yep.

And one other thing, just to be clear. If I equip my office beautifully and I get a really nice equipment lease with a great rate, I should just. On my income statement every month, I should. Where it says equipment, I should put my equipment lease there, because that's. That's accrual accounting. Right, Holly?

No, there's all kinds of rules about that. Too far down in the weeds. But no, you have to actually capitalize the asset you recognize because there's going to be an interest component to what you're paying.

Yeah. And so it doesn't matter what the payment is. It matters what is the value of the equipment. What's the life cycle Spread out. All right, we got to jump from assets because we're going to run out of time. I want to get to liabilities because I believe there are a few things on this list that are going to be jaw droppers for those that are Listening that are still getting accustomed to accrual accounting. So going in order like you said. And when it comes to liabilities, what are you going to have to pay for? First, second, third, first? I think accounts payable is probably at the top of your list. You want to explain that to listeners again because many are, hey, I get a bill in and when I feel like it, I write a check and I pay it or I put it through bill.com and I pay it. Accrual accounting requires different treatment. So do you want to maybe give an overview of this?

Let's talk about supplies. I mean, so you've ordered your supplies, you've received your supplies, you put them in inventory. Well, you owe the vendor for those supplies because they have, they fulfilled their promise to you, they've given you the supplies. But you have a 30 day term on your invoice. So you receive the supplies in April, you pay for them in May. So when you're putting it in inventory, you record the amount that you owe the vendor in your accounts payable. When you write the check, you reduce your accounts payable down by how much you paid the vendor. So at any given point, if you've been delivered goods or services, your accounts payable account is what you owe to the vendor. Now, some of you probably use your credit card to pay accounts payable. So then it just simply moves from accounts payable to credit card payable because eventually you still have to pay for that item, but you recorded it in your inventory or you put it in your expense in the month that you actually received the goods. And so how it walks down your balance sheet to actual payment is, you know, depends on if you're using your credit cards to pay things.

Yeah, great point. So again, it doesn't have anything to do with the timing of when you pay, right? You're recognizing the expense when it's incurred in the period when it's incurred for those supplies that you either are using or that have gone into inventory, right? And then you have this balance of called accounts payable that sits on your balance sheet and you can generally run an aging on it and say, how old are my payables? Am I? Is it 60 days old, 90 days old since I got this invoice in or since I received the services or the products. So it's a just a different mentality than hey, I've got QuickBooks and I just pay bills whenever I've got cash or I have time to sit down and go through it, or whenever my bookkeeper does it.

There this is a completely different time. You know, it's just where, you know, when are you going to recognize that expense?

Right. So it's the discipline of put it into accounts payable when incurred.

Right.

And then pay it whenever you want or pay with your credit card and then pay that credit card whenever you want. But all within that structure. Okay, great. So that's accounts payable. What about, talk to me about accrued expenses. I think that's usually the next one and that's a catch all. Or would you rather jump to payroll accrual next?

Well, accrued expenses would be. We can quickly cover that. Let's say that, for instance, you have a contractor that you use, a consultant that you use, and they're not really, you know, you know that you worked with that consultant for 80 hours in the month of April, but the consultant hasn't sat down and created their invoice yet. And you know that you've agreed to pay this person $100 an hour and you don't have an invoice to record. But when you're closing the month of April, you would actually say, well, I know, I'm aware that I have to pay this invoice. And so you would actually book an accrual to say I owe consultant XYZ $8,000. And you would recognize that expense. And that way when you get the invoice a month later. Some law firms are doing this too. You know, it takes a little while to get their invoices out to you. It makes it where you're anticipating the invoices that are going to come to you because you know that you've used services. Perfect.

Great, great, great way to describe accrued expenses. Let's jump to payroll. Why would payroll need to be a liability on my balance sheet?

So, I mean, most people don't have instant payroll processing. So you've got to. Usually you're paying people a week or two weeks after they've worked for you. They have to have time to get the timesheets all turned in. Then you have to have time to get it processed and sent through the payroll company. And so that, you know, so if you are paying on the 1st and 15th, and the 15th is paying, so let's say April 15th, paid through services received through March 31st. Well, your mark, if you're booking it in the week that you pay it, your March income statement is not going to be correct because those employees worked for you to produce the March revenue and you're paying them in April. So you have to look at any hours that have been worked that you haven't yet paid for and put that into the month that it affected, because those are the hours that produce the revenue for March. Wait.

So wait a second. When that draft of money comes out of my account for payroll, I don't just get to realize all that expense that day, plus their taxes. And sometimes there are other little things.

No, I mean, you, you. I mean, probably you will use that information to book an accrual back into March. I mean, you know, because, you know, usually if you're only a week or two back, you can, you know, once that payroll runs, you split your payroll. You said, well, this payroll, partially paid for March, partially paid for April. So I'm going to put some of it in March with a journal entry and some of it in April. Because, you know, again, just always think about it, what I have and what I owe. If I close today, I still have to pay those people for the work that they've already given me.

And if I could get to just a really basic rudimentary example. Correct me if I'm wrong here, Holly, but think about your seven. You have 14 days in your pay period. Let's say you pay every two weeks, bi weekly, and you're seven days until the end of the month, which means you have another seven day for your pay period. You have another seven days in the next month. And your payroll. I'll pick an easy number. Let's say Your payroll is $10,000. If it all works out where everybody's paid the same and they all work the same hours in the same days and all of those different things, what would happen is you put $5,000 into the month you started in, and the other $5,000 you would put into the next month. However, you paid for it all in the next month.

Right.

And so the reason why we book it as a liability is because it's actually something you owe as of the end of the month. These seven days of payroll, you owe it, but you're not going to pay it until the next seven days of the pay period go past. And then if you pay, let's say five days after, a lot of times, if you end on a Saturday and you're paying on a Friday, then you're six days after or whatever. But that becomes a little bit of work. And somebody who's going to do this has to know debits and credits, how to put journal entries into the computer, into your accounting software, and know what they're doing and how to split or bifurcate between the month periods.

Right.

Anything you'd add there? Did I miss anything?

No, I mean, I think that that's exactly right. I mean, again, because you're trying to create that snapshot. So if we use the March and April, you know, you're trying to Even though on April 7th you paid the payroll, so you don't owe it on April 7 because you paid it. But as of March 31, you owed seven days of work. You owed $5,000 to people for work that's they had already given you. Yeah, and one of my 31st date.

Yeah. And one of my biggest pet peeves, when somebody's looking at cash basis financials and you're looking at labor and you see, you know, it's steady, steady, steady, that it bumps up a month and then steady steady state bumps up a month. They're like, oh, that's when we had the third payroll. Drives me crazy. Because what happens is if your payroll is truly steady, then accrual does it other than like, let's say in one of your practices, the days of the month fall where you're open 22 days one month and then you're open 19 days the next month, that would be the only reason why to go up and down. But most likely your revenue and your practices is going up and down in some commensurate fashion because you're open three less days.

So, you know, you should be watching your payroll as a percentage of your net revenue. And if you're booking it on the you know when you pay it and you have those months where you have three payrolls, you really don't have a true percentage. If you look at the whole year. You know, if you do it that way and you look at the whole 12 months, you're going to be pretty okay. But if you're truly watching it as a percentage of your net revenue, you really do have to isolate down the days that you're paying for.

And if I had a dime for every time one of the listeners to this program have reached out to me and asked me for industry benchmarks on payroll, I would be a very wealthy person. And that being said, if you're looking at cash basis and trying to look at industry benchmarks and match up to those, you're going to be off one direction or the other, right?

I mean, your P and L is going to look great one month and not so much next.

And it gets back to my point earlier of that. Like I was sitting in that meeting and like month by month, the margin was Just bouncing all over the place. We had no way to really see what the practice level, profitability was and how well everybody was doing because. Oh, it's because we had a third payroll that month. Oh, I remember we waited three months and we paid a bunch of supply bills. And so that's what happened. And get all of those various things or you know, on the revenue side, they're saying, oh, well, wait, hold on a second. Oh, that's right, that our biggest insurance payer, they didn't send us any checks that month and so we got doubled up the next month and that's why this month looks bad. Again, having an argument about why they're wrong or right is wrong. Having a discussion about how do we now improve the business from here. That's what we're trying to create. That's the dialogue that accrual accounting empowers. All right, I better get off my soapbox. So here's another surprise. So I think the payroll one might be a bit of a surprise for many listeners. And nothing bad about that. Just we're really anxious to try to educate and help everybody understand. Here's another one that's a bit of a jaw dropper. Talk to me about why you have to accrue or why your employees accrued payroll, pto, vacation or sick leave. What is this? And why does this have to get booked into your balance sheet and show as an expense?

So if you're giving, if you have a formal PTO plan where you're giving people the right to take take time off in the future, you owe that to your employee and that is based on time that they've given you service for. So again, it's an expense of that person's time that produced revenue. So if you're generous and you give people two weeks all at once, then you would put that on your balance sheet at the time. But most people do it based on time served. So they accrue a certain number of hours every payroll period.

All right, let me ask a question here and we'll. Because we need to unpack this just a little bit. So let's say I have an employee and just to use easy numbers, let's say they make $100 a day and they have accrued two weeks of PTO, or in essence that'd be 10 days. There's $1,000 of pay that they haven't worked yet and they haven't taken and used yet. But you're telling me I have to expense that thousand dollars on my income statement right now? And book the other entry onto the balance sheet, which will get resolved once they use the time.

Well, if they. Back to the, you know, if they're earning it as they give you service they're earning, you're paying them $100 a day. And let's say that they're earning that time off at the rate of $10 a day. So what you're going to be expensing is $110 a day up to the point that you have $1,000 accrued on your balance sheet that you owe that person. So again, you owe that person time off. You're going to pay them that thousand dollars while they take the two weeks off, but they're not going to be producing any revenue for you while they're off. They've already produced the revenue that's associated with the expense that you gave with the time off that you gave them, and that's why you do it that way.

Interesting. So again, you have to stop and think about this. Let's say you have 100 employees. So you have a group of seven, eight practices, something like that, 100 employees. So you're telling me I have to keep track of how much accrued PTO every employee has at the end of every pay period. And besides the fact you're telling me now I have to split it between months and do these different things on their pay, but now I have to book any increase in their accrued pto.

So it's really not. Because if you're granting people pto, you're going to have a record of what you owe them. You're going to have a record. I mean, otherwise you're going to let people take off too much or honestly, studies have been shown that if you grant people unlimited pto, they actually take off less time because they don't really know where they stand and they're afraid to ask off. And so you're going to have a system. And so the best, you know, I think the best way to do it is to just, just have a month end report that you run everybody's hours and you know, their hourly rates and you just multiply them out and you know that that's what your accrued PTO balance should be and you book to that change.

Awesome. All right, Holly, any other liabilities that are coming to mind that should be thought about or considered?

Are we going to talk about the deferred revenue? Okay.

Yep. I was not going to avoid that one, but I want to see if there's anything else before deferred Revenue?

Not really that I can think of, I guess, you know, if you have, you know, a loan where you're making quarterly interest payments, you want to make sure that you're accruing that interest expense every month instead of booking that interest, you know, on the quarters when you pay it. So it's basically, you need to think about any kind of payments that you have coming, that you're billed in arrears, that you need to make sure that you're recognizing that expense before you make the disbursement.

Perfect. All right, our last one, let's jump into deferred revenue. This is a concept where you've been paid for something that you haven't done yet. Tell us about deferred revenue and why this is a liability on the balance sheet and has to flow through the income statement accordingly.

No, I mean, the big, biggest example in dentistry is orthodontics. That's the longest service life that you have for that patient. And even if you have the patient signed, which I know some orthodontists do, you know, the case is, you know, let's make up an easy number, $1,000. And regardless of whether you debond with me, you know, you owe me $1,000, that still doesn't mean that you get to recognize that whole thousand dollars immediately because you have to provide service to that patient. Most likely, if they prepaid you, you might have to refund them if they leave. But. And that's why it would be a liability. But the other side of it is, again, the matching principle is to recognize the revenue and the expenses in the period that they are matched together. Like. And so if you have a patient that comes in for adjustments for 24 months, you're spending supplies, you're spending DA time, you're spending chair time, front desk time. Everybody's time to service that patient every month they come in. And so you recognize a little bit of the revenue and you recognize the expenses as you're providing the service, and that matches it together.

And the reason why this sits as a liability is because your technically trying to recognize the $4,000 of revenue, month one, but you're saying because the contract is signed and there's a true contract value, but it's a liability because you haven't earned it yet, right? You've only delivered that first month of service, which is bonding and, you know, getting the patient set up or appliances, whatever's needed, but you have not earned the rest of that yet. It has to be. You have to wait to earn it as you are continuing the treatment and the, and the treatment plan all the way until its conclusion.

So typically you think about the liabilities on your balance sheet are things that you're going to have to pay cash for. This one you're paying in goods and services.

That's a great, that's a great way to say it. That's a great. Yeah, you just articulated that really well. You've, they in essence have signed a contract with you that you're going to provide goods and services for the next 24 months, if that's the term of the case and the treatment plan that's been recommended by the doctor. But yeah, that's, that's a great way to say it. All right, Holly, assets, liabilities, accruing expenses, anything else come to mind before we wrap this up?

No, but I think you're right. I mean, you know, the balance sheet side and the expense side is the easiest place to start if you're, if you're, you know, trying to dip your toe in the water here. And if you do that, you'll start to see, see. Okay, well, I've smoothed out my expenses and I really understand what I have. And then you'll really understand the need to really match that revenue in the proper period.

Yeah, great point. Great point. All right, Holly, again, I can't thank you enough. We really missed Mike today, but you did a fantastic job. Thanks so much for joining on the show.

Thank you.

All right, we learned a lot of great things today. This is episode five, four or part, I should say part four of a five part series. Mike, Holly and I will be getting back together one more time in June. We've already got it scheduled and planned. We're ready to do it and we're going to be doing a full wrap up session where we do a summary, make recommendations and we're even going to jump into how to find the right types of accounting personnel to help you make this transition from cash to accrual accounting. Many, many thanks to you for joining today. This is a wrap for episode, or I should say part four of our five part episode five part series on all things accrual accounting. Happy day.

Thank you for listening to DSO Secrets. Join our community on Facebook Facebook at DSO Secrets and get answers and resources to some of your most challenging questions. If you want to get a copy of the seven secrets of any DSO, go to our website at dsosecrets.com and we will get that emailed to you. Remember, don't go at this alone. Let us be your team while you build your team.