An effective bookkeeping and accounting system is an absolute must for any startup; without it, owners have no way of assessing the overall financial health of the business, identifying problem areas, and making informed decisions. When it comes to cash basis vs. accrual basis accounting for keeping track of finances and for tax purposes, which method makes the most sense for your business?
Cash Basis Vs. Accrual Basis Accounting: It's All About Timing
The difference between cash vs. accrual accounting is actually pretty straightforward, and it all has to do with timing, specifically the timing of recognition—when a business records a transaction.
With cash basis accounting, a business records revenue when it receives payments and records expenses when it makes payments—regardless of when it earns or invoices them.
With accrual basis accounting, a business records revenue on the balance sheet as soon as it earns that revenue, and it records accrued expenses as soon as it incurs those expenses—regardless of when it eventually pays them.
To illustrate the difference, we'll set up a scenario:
-Company A sells $10,000 worth of services to Company B in March.
-Company B pays $10,000 for those services to Company A in June.
If Company A used cash accounting, it would record that $25,000 revenue on its income statement in June, when it received the payment from Company B. However, if Company A used accrual accounting, it would record that $25,000 in March, when it delivered the service and then earned the revenue from Company B.
On its face, the difference between the cash vs. accrual accounting methods might seem small, but the type of accounting system utilized has important implications for the business using it.
Cash Accounting: Advantages And Disadvantages
The primary advantages of cash accounting are its ease and simplicity of recording transactions without complex accounting, such as tracking payables or receivables. Using the cash basis method, a company records transactions when cash enters or leaves its bank account, eliminating the need for accounts payable and accounts receivable on a general ledger, as well as more complex accounting transactions like deferrals and accruals.
The cash basis method of accounting is also useful for obtaining an accurate picture of a business's cash flow at a moment in time. With this method, it's easy to look at a bank balance and understand exactly how much cash you have at your disposal at that moment.
For those reasons, cash basis accounting is often used by sole proprietors and small business owners (specifically those that don't carry inventory and sell merchandise or allow customers to purchase on credit), as well as individuals tracking their personal finances.
The primary disadvantage of using the cash basis of accounting is that it doesn't provide an accurate picture of a business's financial health over the longer term. Let's say that, in the example above, Company A paid $2,000 to outside contractors in March to help provide that $10,000 of services to Company B. With cash basis accounting, Company A's books would show a loss for the financial period ending in March due to the $2,000 payout to contractors. Company A would also show a large profit for the financial period including June, when it received payment from Company B.
Though Company A expected payment for the services it provided to Company B, the books would only show the expenditures (not the expected revenue) for the financial period ending in March, making the business look less profitable than it truly is. Similarly, Company A's books for the period including June—when Company B paid the invoice—would make the business look more profitable than it truly is because that period didn't include the expenditures necessary to provide the services for which Company B then paid.
With cash basis accounting, if an investor looked at Company A's books for the financial period ending in March, they could wrongly assume the business is losing money overall when in reality, it's profitable.
Accrual Accounting: Advantages And Disadvantages
The primary advantage of the accrual method of accounting is that it provides a more accurate picture of a company's financial health over the longer term. Had the accrual accounting method been applied to the above example, rather than the cash method, both the $2,000 that Company A paid to contractors and the $10,000 that Company B paid to Company A for the services it provided would be recorded in March.
Recording these two cash transactions according to the accrual basis of accounting makes it immediately apparent that the ultimate result was an $8,000 profit for Company A ($10,000 in revenue minus $2,000 in expenses).
By recording revenues when you earn them and expenses when you incur them, you're able to see precisely how much your business earns and spends at a specific time in the year, and thereby able to more realistically examine trends, manage finances, and make future strategic plans.
The accrual basis method of accounting is mandatory for many businesses, such as C corporations. The Tax Cuts and Jobs Act (TCJA), signed into law in December 2017, requires businesses with gross annual receipts exceeding $25 million based on the three tax years prior to use accrual basis accounting. Previously, the accrual accounting requirement applied to all businesses with gross annual receipts in excess of $5 million.
Accrual accounting is also necessary to comply with Generally Accepted Accounting Principles (GAAP). GAAP is a set of rules, regulations, and guidelines developed by the American Institute of Certified Public Accountants (AICPA) and the Financial Accounting Standards Board (FASB), designed to ensure consistency and transparency in financial reporting from one organization to another.
The primary disadvantage of accrual accounting is that it's more complex, and therefore more time-consuming and difficult. Accrual accounting involves the use of more advanced accounts, like accounts payable, accounts receivable, inventory, and long-term liabilities, as well as both general and industry-specific standards and rules. It also requires the payment of income taxes on revenue before it’s been received. This added complexity means you'll likely need to hire an experienced accountant or finance firm to manage your business's books rather than doing it yourself.
Cash Basis Vs. Accrual Basis Accounting: Which is best for your business?
If you're considering cash vs. accrual accounting methods and trying to decide which is appropriate for your business, ask yourself these questions:
- Will you be seeking VC funding for your business?
- Will your business earn more than $25 million per year in revenue?
- Will you be registering with the SEC?
- Is an IPO, merger, or acquisition in your company's future?
If the answer to any of these questions is "yes," accrual accounting is the right choice for your business.
Compliance with GAAP financial reporting standards (a major component of which is full accrual basis accounting) is required by the United States Securities and Exchange Commission (SEC) for all publicly traded and regulated companies. And while it's not federally mandated by the Internal Revenue Service (IRS) for private companies earning less than $25 million per year, GAAP compliance is necessary for any financial statements or reporting going to third parties like board members, investors, bankers, and auditors.
Ready to get your startup GAAP-compliant with accrual accounting?
Whether you're just getting started or ensuring that you're prepared for growth, GAAP-compliant accrual basis accounting can help you better understand the financial health of your business and make the best decisions for its future.
Zeni is a full-service finance firm that delivers startups and small businesses GAAP-compliant bookkeeping, accounting, tax, and CFO services at a set monthly fee based on how much you spend to run your business. Many traditional accountants and finance firms, on the other hand, charge an hourly rate for their services, which can become an expensive surprise every month.
Among the startup founders and owners we work with who previously used a traditional finance firm, many found that they save 50-80% per month on bookkeeping services by switching to Zeni.