Accrual vs Cash Basis Accounting for Startups

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Entrepreneurs over the years have asked me whether or not they should do accrual or cash basis accounting for their startup. The general idea for accrual accounting is that as income or expenses are signed for they should be put on the books whereas with cash basis accounting you only worry about it when money changes hands. So, with accrual based accounting as soon as you receive the purchase order from a client you put the revenue on your books (assuming it is all recognized at once). With cash basis accounting you don’t count the money until you receive payment for it — even if that is 60 days after you received the purchase order.

Here are some quick tips to keep in mind regarding accrual and cash basis accounting for startups:

Almost all startups should be cash basis as that most aligns with the nature of trying to get a business off the ground and being cash strapped (the number one reason startups go out of business is that they run out of money)
If you get prepaid for your service or service component of a product sale (like support), accrual is the way you should go since you can use the capital without paying taxes on it until it is recognized via the obligation being completed (e.g. it is December and you just got prepaid $12,000 for 12 months of your SaaS product, you only recognize $1,000 for the month of December for the purposes of the IRS for the year, yet you still have $11,000 in the bank to start the new year that you haven’t recognized yet)
The IRS requires the accrual method if you average more than $10 million in revenue and have inventory, so there’s no choice at that point

Accrual and cash basis accounting are easy to understand once you go through a few scenarios with your accountant. Most startups should do cash basis accounting as cash coming in and going out most closely align with a business in the seed to early stage.

What else? What other thoughts do you have on accrual vs cash basis accounting for startups?

Update: See the comments for several people that recommend accrual accounting instead of cash basis accounting.

Comments

5 responses to “Accrual vs Cash Basis Accounting for Startups”

June 6, 2011

Mike Schinkel

Not sure if I agree that startups should be cash basis. Cash basis in my experience is for those who simply don’t have their accounting procedures set up well enough yet to understand their cash flow. Ironically, my company is currently running on an ad-hoc cash basis, but I am taking steps to move to accrual ASAP.

Use of the Mobley Martrix from IBM can help with understanding cash flow when on accrual:

See:

Click to access Mobley_Matrix.pdf

Covered here:

Also:
http://www.financialscoreboard.com/history.html

Google for more.

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June 6, 2011

Geoff

While monitoring cash flow is important at any stage of a business, I’m a fan of accrual accounting — even for startups, and especially for startups that might receive prepayment. There’s a small cost/effort associated with recognizing revenue as it’s earned and expenses as they’re incurred. The benefit, for me, lay in seeing an accurate picture of how much money you’re actually making (or losing). If you only have the bandwidth to keep a handle on cash flow, then so be it, but if you’re so inclined, the extra effort to go accrual is worth it. Many businesses have run into abrupt and unexpected trouble by thinking about that month’s net positive cash flow as profit.

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1. June 6, 2011
  
  Kenji
  
  I’m in agreement with Geoff. Fortunately, many accounting systems that startups traditionally use (QuickBooks for example) allow easy toggling between accrual and cash basis from a financial reporting standpoint. On the revenue side, some of the revenue recognition accounting has gotten overly complex so looking at a deal on a cash basis isn’t a bad idea when accrual accounting isn’t required. Where I think accrual accounting may be more important is on the expense side. I’ve seen too often where entrepreneurs don’t enter their vendor bills in their accounting system and just record expenses on a cash basis. This can be a major problem and cause startups to understate their expenses and not have visibility into their liabilities. Also, if you’re planning for your startup to raise capital, obtain a bank loan, or grow beyond $10 million in revenue (as David pointed out) you may end up being required to move to accrual accounting.
  
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June 7, 2011

Sanford

I agree with Mark, Geof and Kenji. I prefer accrual as well. it shows the economics of your business. IMO, that is huge, even at start-up. and like Kenji said, you can instantly toggle between cash and accrual in quickbooks if you need.

i have never found any real added value from cash basis accounting. the cash balance on your balance sheet is just that..the summation of your cash transactions, even if you are running accrual accounting books.

what gets challenging is when you start booking deferred revenue on the liability side of your balance sheet, i.e., revenue received or billed but not yet earned (i.e., the service has not yet been rendered). many businessmen (particularly non-accountants) struggle with deferred revenue. for instance, i’ve met with heads of community banks, who i could tell, had no grasp of deferred revenue. nevertheless, deferred revenue recognition also shows more realistic economic operations of your business as well.

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June 7, 2011

David Cummings

Awesome, thanks guys for the great comments. I added a note in the post to see the comments for the accrual account recommendation. I agree accrual accounting is best once the startup is off the ground but in the earliest of stages I still stand by cash being king.

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