As a startup owner, you're probably overwhelmed by your lengthy list of to-dos: hiring the best team, focusing on product development, winning customers, and raising money to keep the business growing. Amid these tasks, balancing books and figuring out the best accounting method to track and manage your finances take a backseat.
However, your startup's long-term success and profitability start with a solid understanding of your finances. Choosing a suitable accounting method can steer your business in the right direction, as this directly impacts revenue recognition, financial statements, funding prospects, taxes, and other crucial business decisions.
Even if you hire a dedicated accounting team, it still pays to understand the different types of accounting methods so you can make informed financial decisions that improve your startup.
In this article, we discuss two popular accounting approaches so you can build a solid and sustainable financial strategy.
What Is An Accounting Method?
An accounting method is a formal system to track and analyze cash inflows and outflows. It helps you summarize your business transactions into financial statements that you can use to evaluate your startup's performance.
It's common to confuse accounting with bookkeeping. While bookkeeping records day-to-day financial transactions, accounting focuses on the high-level analysis and evaluation of your financial statements.
2 Major Types Of Accounting Methods And Systems
Cash and accrual-based accounting are the primary accounting methods businesses use to track their transactions. Let's take a closer look at the differences between them.
This is the simpler of the two methods and allows you to quickly understand your revenue and expenses. In this method, you record money when it's paid or received.
For example, let's say you pay for inventory using cash. You record the transaction as an expense only when you settle the invoice and not when you receive the goods. Similarly, you register revenue only when the customer pays you and not when you deliver the products or services.
You may opt for cash-basis accounting if:
- You run a small business and don't deal with extensive inventories
- Your business transactions are in cash, and you don't purchase or sell goods on credit
Accrual-based accounting helps you observe your company's long-term progress. This method is handy when pitching to investors and making future business decisions. Accrual-based accounting recognizes revenue and records expenses as soon as you bill your clients, irrespective of whether you’ve been paid or made payments yet.
For example, imagine your team managers conducting appraisals to determine employee bonuses in the first quarter of every year. However, the bonus gets paid to employees only in the third quarter. In accrual accounting, you record the bonus in Q1, even though the actual payments don't happen until Q3.
You might opt for accrual accounting if:
- Your startup makes more than $25 million over three years. In this case, performing accrual accounting for GAAP compliance is mandatory.
- You're serious about business growth and plan to raise funds from investors and venture capitalists.
- You want clear and accurate business financial statements to help you with strategic decisions.
How Double Entry And Single Entry Accounting Fit In?
We've discussed recording transactions and how cash and accrual accounting differ in terms of timing. But what does it mean to record a transaction?
This is where the argument for single vs. double-entry bookkeeping comes into the picture. Here's a quick overview of the differences between these two processes.
In single-entry accounting, you record each transaction (both income and expenses) only once in your accounting books. It lists income and expenses in the same sheet, with positive values for inflows and negative values for outflows.
However, these financial statements are easier to produce and don't require complicated accounting software. Thus, single-entry accounting works best for smaller startups that use cash-based accounting.
In a double-entry bookkeeping system, you record each transaction twice: once in the debit column and the other in the credit column. You record a corresponding debit for the same amount for every credit in the other column. The method follows this principle:
Assets = liabilities + equity
Double-entry bookkeeping forms the foundation for a balance sheet and is a must for accrual accounting. It allows you to identify any data entry errors in your financial records and gives you a complete idea of your financial activity. With these details, you can better track your finances over time for better decision-making.
What Type Of Accounting Method Is Best For SaaS Startups?
SaaS startups differ from traditional business models because they follow a subscription-based revenue model. Your revenues often fluctuate as customers opt-in, opt-out, upgrade, and downgrade. Additionally, you aren't likely to receive income immediately, as most customers pay over an extended period.
This is why accrual accounting works best for SaaS startups. It provides detailed and accurate information about your company's financial health, even though your cash reserves might vary.
Why Accrual Accounting Is Better For SaaS Startups?
There are a few other reasons why accrual accounting is better for SaaS startups:
- It makes you GAAP compliant by standardizing your business accounting through transparency and consistency. This is a great advantage when dealing with investors, banks, or IRS auditors.
- Gives a more accurate picture of your business's financial health.
- It helps with strategic planning, as you can accurately forecast and estimate expenses and income.
Can I Use Multiple Accounting Systems And Methods At The Same Time?
While the tax code allows businesses to calculate taxable income on an accrual or cash basis, choosing one method and using it consistently is preferable. Alternatively, consider the following accounting methods to make the best of both worlds.
Modified Cash-Basis Accounting Method
Modified cash-basis accounting follows a hybrid approach as it combines cash and accrual accounting strategies. In this method, you record short-term assets on a cash basis, while long-term investments use accrual accounting. It helps you better understand your financial health without switching to full-scale accrual accounting.
If you want a more accurate and long-term outlook on your finances, you may opt to switch accounting methods. Switching from cash to accrual accounting is a great idea if you're growing quickly or want to provide more accurate financial information to investors.
The first step to convert your accounts from cash to accrual is to adjust your books to include accrued and prepaid expenses and accounts receivable. Then, subtract cash payments, cash receipts, and any customer prepayments. Once you've balanced your books, the next step is to fill out Form 3115 with the IRS and complete the formal transition to accrual accounting.
Accounting For Startups And Leveraging Accounting Software
Accounting is a must for startups as it helps you track the money flowing in and out of your business and assists with financial planning. Choose a suitable accounting method — cash or accrual — depending on your startup size and business goals and objectives.
Cash accounting works best for small businesses, and accrual accounting is ideal for startups with long-term growth plans. Double-entry bookkeeping is best for accrual accounting as it provides more detail and accuracy. Remember that you can switch to accrual from a
modified cash-basis accounting method as your business grows.
You can handle accounting manually using spreadsheets or with the help of automated, specialized accounting software for SaaS startups. However, the manual process can be time-consuming, tiring, and prone to costly accounting errors. Learn more about automating your accounting methods here.