The Big Difference Between Cash vs IOU

Selling your products or services is such a great feeling. Seeing the email about another sale or hearing your phone go "cha-ching"! 

When you sell high-end services or products, we often offer our customers a payment plan—this where it can get tricky.

Knowing what is revenue when it comes to payment plans and what are IOU's is key.

Cash vs IOU

There is a concept of cash vs. paper money, or IOU, when it comes to revenue and payment plans. Here's why you need to know the difference between actual cash versus an IOU. 

This post came from a reader (who has some accounting knowledge) and asked me to talk about this subject.

See, she had clients boasting about how much revenue they earned one month while also stating the money was coming in from payment plans.

Money "earned" from payment plans is what you would consider an IOU. It is not revenue that can be claimed as income at the time of sale for most entrepreneurs.

WHY?

Because there are two types of accounting: cash basis and accrual basis accounting. And there's a big difference between them.

Most entrepreneurs are on cash basis accounting. Accrual basis accounting is typically done by an accountant and there are more rules around it. 

If you don't know whether you are a cash or accrual basis, you are cash. It can also affect your taxes.

Cash basis accounting means you record revenue when you earn it and record payments when you make them.

Have you ever heard of accounts receivable? Money owed to the business? Well, this falls under accrual basis accounting.

Cash basis accounting does not have accounts receivable or payable.

What does this mean?

When you sell a product or service, and you receive money for that transaction via Stripe, PayPal, Square, etc., that is cash in the bank.

When your customer selects a payment plan, and you get paid for the first installment, you have cash in the bank for that payment. Revenue (sales) are on the books for that payment only.

Cash went up, and so did revenue. Win-win!

What is a Receivable or "IOU"

When a customer selects your payment plan option, they will pay you the first installment at the time of purchase. Great, this is cash in the bank.

If there are six payments in total, five remain, which is future income but not cash. The cash, or revenue,  doesn't exist yet. It is an IOU from your customer.

Example #1:

In January you sold a $10,000 coaching program and offered a six-month payment plan. Any money paid to you in January is income for that month. The rest of the money is an IOU.

Example #2:

You launched a membership. Only the monthly fee paid to you that month is income. If anyone paid a year upfront, that is also income for the month it was paid. The monthly fee you will collect is future revenue.

Cash Basis Income

  • When you make a sale and receive money for it, the revenue is recorded in the month you received the money
  • Future payments from a customer on a payment plan are not income (yet)
  • You can project your future income from money owed on payment plans 

 Understanding that there is a difference between money in the bank, cash, and money owed to you, an IOU, is crucial to understanding how much money your business has.

When you offer payment plans, you know what you will earn in future months. You cannot claim this money as revenue until you are paid the cash!

With payment plans, you can project or forecast your future income based on the amount of the IOIU.

The cash you receive in a month is your monthly revenue.

The Cash Basis Rules of Income 

  • Cash (or credit) received is cash in the bank account
  • Money received is reflected in the bank accounts on the balance sheet
  • A sale is recorded as revenue/income in the month you were paid
  • Money owed to you in the future is called an IOU
  • Cash basis accounting does not have accounts receivable
  • There is no guarantee you will collect all the future money owed to you on payment plans

 Understanding how revenue works in your business is crucial to financial planning and understanding your financial statements.

Don't get caught in the trap of thinking you earned more revenue in a month than you did.

 

For more information about revenue and launches, read the post Revenue vs. Profit

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