Learn to recognize if you’re ready to move to smarter accounting.
Smarter accounting is simply accounting that helps you stay smart. The stage at which your company is, influences whether you are ready to move to Accrual Accounting, which is a better method for financial reporting and control. This is because accruing reflects the realities of a growing business better than cash accounting and positions your company ahead for the next stage. Public companies, for example, have no choice, they are required to use the accrual basis for accounting.
First let’s define what such an accounting-sounding term means. Accrual Accounting is an accounting method that records revenues and expenses when they are incurred, regardless of when cash is exchanged. The big advantage of an accrual system is that it can provide better information for management decision-making. The disadvantage is additional accounting costs and a diminished ability to show less expense and more profit just because you pay vendors late (which is actually a good habit to avoid!)
Sooner or later, your startup will reach a stage in which using an accrual basis for accounting can help you grow smarter. In this article, we explore five signs that can point you to the fact that it may be time to shift to this method of accounting for revenues and expenses.
Five signs that indicate your startup is ready for accrual accounting
In the ideal world, all companies should choose accruing from day one, as it is a method that makes you more disciplined and gives you a more accurate and realistic financial view of your business. But startups never start in an ideal world, and many begin by using the cash method and eventually change. These are the five signs to be aware so you know when you’re ready.
Most small companies begin by having a vast majority of their transactions on a cash basis. There can be significant clean up work to match income and expenses to the proper period, and when the company is too small, this is a cost that may not be justifiable. It used to be that you would record all your bills/payments (made via check) and invoices/receipts (received also via check) and then at the end of the month reconcile to your bank account. With the proliferation of cloud accounting systems, which integrate with bank and credit card data, the model has flipped to one where transactions are initially posted to the accounting system based on the bank and credit card records, and then the source documents are often used in small companies without an accounting process to adjust the cash-based entries.
Almost all startups move to an accrual basis once they start getting prepayments from customers for services, including online services, they provide. This is what eventually happens in many current tech business models, and when this is so, accrual is the right solution: it lets you use the money received without paying taxes on it, and recognize income (revenue) when the obligation (i.e. service delivery) is completed.
2. Stable and predictable cash flows
A common barrier for accrual is that unstable cash flows force companies to use new cash to pay for old expenses. We’ve all been there: you finance your operations by delaying payments to suppliers until you have the cash. In a way, this is the intuitive and often times necessary way to operate for small companies. However, doing this while accounting on a cash basis can diminish the usefulness of you financial statements, because it does not reflect the true state of your business.
A common problem is you let payables build up over many months while trying to raise money, then you raise money and pay off a bunch of old expenses. But when you want to budget for the future with your new cash, you don’t have a good historical record of the timing of what was expensed, because a big portion of the expenses were lumped into the month when the money came in.
If you have lived through the example above, now that you have money in the bank and have experienced the struggle first-hand creating projections without a meaningful historical record, it may be a good time to move to an accrual basis. With cash flows now more stable and predictable, you can move to accrual accounting and get in a position to better understand your business going forward.
3. A venture round
For a potential investor to understand the nature and the realities of your business through your financial statements, it will be necessary to move from a cash to an accrual accounting system. This is because cash accounting makes for imbalanced accounting, and therefore may distort your true cash flow and the nature of your expenses. If you’re venture-backed or planning to be, it is always smarter to be on accrual basis or to move to it quickly once a round is on the horizon.
Eventually, your VCs will require this change, either right after money comes in, or, if your cash method distorts reality beyond their comfort zone, they will demand it before the round. This can mean one thing every CEO dreads: slowing an investment round while your accountants change your accounting system. Sometimes this takes even longer, as once accruing is on, modeling and forecasting will need to be re-adjusted based on the new numbers. If venture money is on your near horizon, do not miss this sign and move to Accrual Accounting before they ask you to.
4. Financial audits on the horizon
The fourth sign that indicates you may be ready to move to Accrual Accounting is if your company is or will be subject to financial audits. These are quite common when outside investors come in and want a clean slate in terms of understanding all business liabilities (for example, to ensure their money goes to growing rather than paying past debts). Additionally, when there is potential M&A activity, accrual accounting will make your life easier by reducing the friction of any transaction for your company, and often is a requirement for large acquirers.
In the United States, GAAP (Generally Accepted Accounting Principles) is the standard for preparing and reporting financials statements and thus, it is required by outsiders who need to understand your business. When an audit is performed, a company’s revenue and expense recognition has to reconcile with GAAP, which means accrual accounting method needs to be applied.
5. You need serious modeling and financial management
The final sign that indicates you’re ready for Accrual Accounting is your own need for useful financial statements that enable your company to do accurate modeling and sound management. When your team is ready to manage the business using financial statements that reflect the reality and the true financial health of the company, an Accrual Accounting method trumps a cash method as it provides an accurate view of the drivers of cost and revenue.
Unfortunately, it is quite common for small companies that use cash accounting method to run out of cash before they even realize it, adding a level stress and uncertainty that could have been easily avoided. Accrual Accounting can give you and your team a real picture of your resources and of your financial responsibilities through time, enabling you to plan with the confidence that the numbers reflect reality. It also allows businesses to manage and plan their financial activities and future in real time instead of “after the fact”.
You will be there no matter what
Eventually, all companies move from cash to accrual as they grow. A move from cash to accrual should be part of the strategic advice you get when your company is ready for a CFO. Before that, an approach where the accrual basis is used partially – it can be done, just ask us! – can be a way to avoid the full costs of the effort, get started on this method of accounting, and attain a better position for sound financial planning, faster investment and accurate modeling for the long-run.
Photo courtesy of Christopher Michel.
To grow faster, follow their footsteps and learn from their mistakes.
For this article, I found a quote from Steven Dunn that says that “You can never make the same mistake twice because the second time you make it, it’s not a mistake, it’s a choice.” Quite fitting regarding how we can learn strategic finance lessons from second-time CEOs and avoid some of the mistakes they made in their startups the first time around. At Burkland Associates, we give strategic finance cover to many CEOs that have been there before, here are some of the lessons we’ve learned from them:
A few years ago, RedRocketVC came up with a checklist for startup success. One of the items on their list is “Flexibility to fine-tune model and navigate challenges.” We see it and hear it from our CEOs time and again: modeling is one of the very few “must haves” for any startup. For a startup, business modeling and finance modeling is exactly the same thing. It may seem like a theoretically painful process, especially early on, but it is definitely one that will yield many benefits. A sound financial model that you can iterate over time, provides clarity on the current business and also illuminates the strategic choices available. Furthermore, this model will focus product, sales, business development and management on the same strategic plan and the levers available to make it viable.
Another reason to invest time in modeling is that a sound financial model will help you see the holes in your go-to-market approach that an experienced investor will detect at first sight, enabling you to bulletproof your investor pitches. Also, strong financial modeling will help a founder show investors the tangible steps to transform their idea first into a successful revenue model (generates revenue but burns cash) and eventually into a successful business (generates both revenue AND cash!).
Although good accounting is a basic skill every startup needs, its role needs to be understood. It is natural for a good accountant to become a “right-hand” guy for a CEO early on. After all, the accounting person usually knows more about the overall business than other management team members. Thus the CEO will often use them as a sounding board for discussing future plans for the business.
This is where things can go wrong. Good accountants are trained to look in the rearview mirror to make sure you do not leave out anything from the financial scorecard that provides an honest assessment of historical company performance. What they are not trained to do, however, is look out the front windshield and see what’s coming and/or which strategic turn the company should take.
That is the role of a strategic finance professional, who can use both the rearview mirror as well as look out the front windshield to help a company navigate around the obstacles and find the opportunities in the road ahead. Accounting and strategic financial professional are very complimentary and should be brought in as early as possible in a startup’s life — and remember, they are more affordable than ever since you can rent both in the new sharing economy!
The third lesson in finance we can learn from second-time CEOs concerns financial discipline. Financial discipline implies running your business based on both your financial model (which is forward-looking) and your accounting (which is backward-looking). Take these two extremes. First, most first-time CEOs have a good innate sense of their monthly burn (they usually are signing the checks!) and yet they are often surprised when the money runs out.
Why? Often founders do not want to really think about what is happening to their dwindling cash and without a true cash flow statement it is easier to not think about what is coming. Real financial statements with a solid cash flow statement provides founders with an unambiguous picture of what is happening to their cash including how important payment terms and collections are to making your payroll in the coming months before that next fund-raising round. This becomes especially important with the big-name clients that often will only accept 60-day payment terms when most of your own expenses need to be paid in less than 30 days.
Strategic finance as an early partner to grow with confidence
Like second-time CEOs, most successful first-time entrepreneurs eventually come to realize the finance function is more than just parental supervision required by their institutional investors. The only question is how much time (and opportunity cost) passes before they recognize that strategic finance is a vital ongoing partner in company success…just like development, sales, marketing, and customer success.
Photo courtesy of Christopher Michel.