A question Burkland’s startup accounting team frequently receives from founders is, “should I use cash or accrual accounting?”. Each method has its pros and cons, but in most cases, we advise accrual accounting for startups that are serious about scaling.
The Difference Between Cash vs. Accrual Accounting
The key difference between cash and accrual accounting lies in the timing of when transactions are recorded:
- With cash-based accounting, revenue is only recorded when payment is received, and expenses are recorded when they are paid.
- In contrast, accrual accounting records revenue when it is earned and expenses when they are incurred, regardless of whether or not payments have been made or received.
The Benefits of Accrual Accounting for Startups
- Accrual accounting allows for more accurate financial statements to be generated as the numbers will reflect all of your company’s activity rather than just tracking the flow of funds.
- Additionally, it can provide information on outstanding accounts receivable and accounts payable, which helps with budgeting and cash runway management.
- Accrual accounting also allows for better visibility into the long-term financial health of your business, since future income and expenses are taken into account instead of just current ones.
- Accrual accounting is required for your startup to comply with generally accepted accounting principles (GAAP)—required for public companies.
- For all of these reasons, prospective investors and lenders will want and expect to see accrual-based accounting when they review your startup’s finances during due diligence.
When Should Startups Use Cash Accounting Instead?
Despite the benefits of accrual accounting, cash accounting may be a good choice for very early-stage startups (i.e., pre-profit, pre-seed) since it simplifies the accounting process, keeps accounting costs low, requires minimal record-keeping, and can better manage working capital and ensure liquidity. Cash accounting may also be the best choice for early-stage startups that have a high level of uncertainty regarding future sales or expenses.
Once a startup begins to scale, generate profit, and raise capital from investors, accrual accounting is the way to go.
Once a startup begins to scale, generate profit, and raise capital from investors, accrual accounting is the way to go. Burkland’s startup accounting team often helps early-stage companies make the transition from cash accounting to accrual accounting as they continue to scale and begin to generate profit.
Making the Switch to Accrual Accounting for Your Startup
- The first step is to start recording income and expenses when they are earned or incurred rather than when cash payments are made or received. This means that income should be recorded when services have been rendered, products sold, milestones have been met, and the benefit has been received by the customer instead of waiting for a payment to be received. Expenses should be recorded when they are incurred instead of waiting for them to be paid.
- The next step is to set up a chart of accounts that reflects the different types of expenses and income associated with accrual accounting. This will help ensure that transactions are recorded accurately and in the right categories.
- It is also important to familiarize yourself with generally accepted accounting principles (GAAP) so that you can ensure your financial statements meet all requirements and regulations. It is important for the accounting team to keep a detailed account of what makes up the accrual accounts that reflect the difference in the timing between cash and accrual (i.e. prepaids, deferred revenue, accrued expenses) at the end of every reporting period.
- Schedule a regular time to review your financial reports with your management team at least once each month. This will provide insight into performance over time and help identify any necessary adjustments in order to achieve the best outcomes.
Summary
While cash accounting may be a good choice for startups in the earliest stages of growth, accrual accounting generally offers greater visibility into a startup’s finances that can be used to make more informed decisions about future investments and operations. Contact Burkland to request more information about how we can help streamline and improve your startup’s accounting.