Accounting can be more complicated than you expect. Even if you feel completely comfortable monitoring your personal finances, once you found a startup, there’s more to consider. Specifically, companies have to factor in accounts payable (AP) and accounts receivable (AR). That means you’re accounting for money that hasn’t technically changed hands yet.
To capture that, our team at ShayCPA generally recommends that startups use accrual-based accounting. While some small businesses can get away with cash-based accounting, which doesn’t factor in AP or AR, accrual-based accounting has some serious benefits.
In the United States, accrual accounting is required by Generally Accepted Accounting Principles (GAAP), whilst cash basis is not. Investors will frequently want to see your “GAAP-based financials” or ask questions during due diligence like, “Do the financial statements conform to GAAP standards?”
To help you get a feel for these two different types of accounting and the pros and cons of each, we’ve built this guide.
The basics of accrual accounting
As we mentioned, accrual-based accounting captures AP and AR. To do that, this accounting method records revenue when it’s earned and records expenses as they’re incurred.
That means that you would record revenue for a project as soon as you send the invoice, not once the invoice is paid. Similarly, you would record an expense for an upcoming bill as soon as you receive the bill, not once you submit the payment.
You can compare accrual-based accounting against cash accounting. With cash-based accounting, you only record revenue when you’ve actually received the money. Similarly, you only mark down expenses as that money leaves your account. That means cash basis accounting doesn’t take accounts payable and accounts receivable into account.
For a quick comparison, check out this chart:
|Accrual-based accounting||Recorded when earned||Recorded when incurred|
|Cash-based accounting||Recorded when money is received||Recorded when money is spent|
Some companies blend accounting types. They may apply cash basis accounting for their bookkeeping but file their taxes on an accrual basis, for example. That said, cash-based accounting is generally only recommended for small businesses.
That’s partially true because the IRS has specific rules around which type of accounting your startup needs to use for its taxes. If your gross receipts average more than $27 million annually in 2022 (increased from $5 million by the Tax Cuts and Jobs Act) over a period of three years, you’ll need to use accrual basis accounting. Plus, the Securities and Exchange Commission (SEC) requires accrual accounting (GAAP) for publicly traded companies.
If you want help identifying the best accounting type(s) to use for your startup, don’t hesitate to discuss it with our team of CPAs.
Why accrual-based accounting matters for startups
When you monitor your expenses in your personal life, you probably use cash-based accounting. You plan for when a paycheck will hit, sure, but you don’t consider that money yours until it’s deposited into your bank account.
On a personal level, this works. But when you’re founding and scaling a startup, it’s important to be able to look — and plan — ahead. You’ll have a much easier time doing that if you’re using accrual basis accounting.
To drill down further, here are a few distinct areas where accrual-based accounting can be helpful.
- Subscriptions: Since many companies, particularly startups, both pay for and charge via subscriptions, accrual accounting can be particularly helpful. If a customer signs up for a year of your service, for example, it allows you to factor in the revenue you’ll collect month after month. Similarly, if you pay for, say, a software service on a monthly basis, accrual basis accounting makes sure that upcoming expense is considered as part of your overall financial picture. Check out our blog post on revenue recognition that drills deeper into the topic.
- Planning ahead: On that note, accrual-based accounting gives you more clarity as you look ahead. Cash-based accounting makes it hard to see what’s coming up in terms of expenses and revenue. Accrual accounting, on the other hand, helps you record things in advance and take your assets and liabilities into account, which can give you valuable insights as you plan to scale your startup.
- Smoothed-out financial reports: Cash-based accounting means you’ll see every spike and dip as it occurs. With accrual-based accounting, you can get a better idea of the bigger picture. Say your company sees a spike in sales during the holiday season. With cash basis accounting, you’ll see that all recorded in Q4. That could, in turn, make Q1 look measly. With accrual-based accounting, you’re already looking ahead. This helps to smooth out the highs and lows to give you a more accurate idea of your startup’s overall financial health.
- The matching principle: This principle says that to get the best picture of a company’s finances, that company should record revenue in the same time period as the expenses that help to generate that revenue, and vice versa. Say you pay for a sponsorship at a trade show, but it takes six months to get the invoice paid by the client that sponsorship attracted. With cash-based accounting, that expense is recorded in a separate quarter from the revenue. Accrual-based accounting makes it easier to track those two things together.
- Investors: You want potential investors to be able to see not just where your startup is now, but where it’s headed. With accrual-based accounting, you can give them a clearer picture there. And if your startup is growing, accrual accounting gives you the means to demonstrate that growth by showing upcoming revenue, too.
Accrual basis accounting drawbacks to consider
Accrual accounting requires more time and work. With cash basis accounting, you pretty much just need to monitor your accounts. But with accrual basis accounting, you need to track and factor in accounts payable, receivables, deferred revenue, payroll accruals, and stock compensation expenses. The main drawback with accrual accounting is that it might require you to hire a bookkeeper or an internal accountant to make sure everything is properly recorded and projected.
The other big drawback to consider with accrual-based accounting centers around cash flow. Your startup might look like it’s booming because you’re anticipating sizable chunks of revenue in the coming months or quarters. That doesn’t mean, however, that you have that money on hand now. If you only look at your accounting on an accrual basis, you might think you have more to spend than you actually do.
Ultimately, while we generally recommend accrual-based accounting for startups, we only do so in tandem with careful cash flow tracking. If you want help with both, we’re here. To learn more about your accounting options, to get started with accrual-based accounting and cash flow tracking, or for any questions you might have, contact our team at ShayCPA.