Defining cash-based and accrual-based accounting
Timing is the key differentiator between cash and accrual accounting.
Cash accounting – The transaction is recognized (or accounted for) at the time the cash is received or spent.
Accrual accounting – The transaction is recognized (or accounted for) when the revenue is earned, or the expense is incurred.
What the difference means
You just hired your first employee. Unfortunately, they do not come complete with a laptop. You find the perfect one for $1,500 and pay for it with cash. With cash-based accounting, you would recognize the entire expense in this month’s records.
However, you know the computer is going to provide value and help generate revenue over the next three years. With accrual-based accounting, each month you would recognize the incurred “depreciation expense” ($1,500 divided by 36 months equals $41.67 per month).
How does that work if you just spent the cash? The $1,500 is categorized as a fixed asset. Each month $41.67 will be expensed as “depreciation expense.”
Subscription-based companies would especially struggle with cash-based accounting. They often charge a monthly fee, but most customers will opt for the annual payment (which provides an overall discount for the year). For example, the price is $150/month or $1,200 for paying upfront for the year.
So, with cash-based accounting, $1,200 would be recognized in month one, and $0 would be recognized in months 2-12. With accrual-based accounting, the $1,200 would be categorized as “deferred revenue,” and we would recognize $100/month for months 1-12 (as it is earned).
One major scenario where accrual-based accounting is better for subscription-based companies is refunds. If a customer cancels after one month, the company issues the refund and the subscription simply ends.
If they were using cash-based accounting, they would recognize $1,200 of revenue in month one and negative $1,100 in month two (which is not accurate and doesn’t look good on reporting).
Why accrual is the way to go
Cash accounting is great for mom-and-pop type of establishments and other businesses that really only evaluate their business based on cash flow. A consultancy is a type of business that is more likely to use cash-based accounting. Their main expense is paying their consultants, and those payments are directly based on the revenue received for that time period. They also aren’t as likely to apply for a business loan or try to raise venture capital.
Accrual-based accounting is the way to go for startups. Not only is it expected by potential investors (they much prefer to see accrual-based accounting and may demand it before agreeing to invest), it’s also a more strategic option. Cash accounting can lead to spikes in revenue or expenses that aren’t truly reflective of company’s financial health.
“What you get with accrual-based accounting is a much more representative set of financials that reflects the condition of the company at any given point.” – Early Growth CFO Sirk Roh
In terms of what’s legal and expected by the IRS, either cash-based or accrual-based accounting is perfectly acceptable. As long you account for all revenue (so they can accurately tax you), the government does not care which method you choose. The true difference is how you can leverage the information you get from these processes to scale your business.
It’s not too late
If your business is well under way and you’re using the cash-based method, do not panic! We see startups all of the time who have been rocking and rolling with their business using cash-based accounting. They usually reach out to us at the point they are ready to start fundraising. There are two ways to “recover” if you’ve been using cash-based accounting.
- Just start fresh the next year, especially if it’s late in the year. Don’t complicate your life further and create unnecessary work if you don’t have to.
- Work with a professional to back track and essentially redistribute your accounting. The more transactions you have, the harder (and more expensive) this process is, but that shouldn’t stop you from getting on track now.
While it’s never too late to switch from cash-based to accrual-based, especially if you’re ready to fundraise, we do not recommend waiting. If you’re just getting started, get off to a strong start with accrual-based accounting.
Other resources you may find helpful:
10 Essentials for Setting Up Your Accounting Function
Five Things to Know About A Chart of Accounts
Questions or Comments? Reach out to EGFS
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