For most startups, the focus is on growth. Unfortunately, many entrepreneurs are not well-versed in accounting methods and early financial decisions can greatly impact the long-term success of a business. When starting a business, it is crucial to establish strong, sustainable financial practices from the beginning. Leaving these decisions for later can cause significant challenges and obstacles for growth down the road. Determining which accounting method your startup will use is one of the first steps that must be determined.
While cash-basis accounting is a common method for many entrepreneurs and startups, it can damage the financial health of a company. Startups seeking funding and attempting to grow quickly may benefit from accrual accounting. Keep reading to learn why cash-basis accounting is not the best option for your startup.
What is cash-basis accounting? – With this major accounting method, revenue and expenses are recognized when cash is received or paid out. Revenue is only included on income statements at the time cash is received, and expenses are recorded only at the time cash is paid out. Commonly used by small businesses or for personal finances, cash-basis accounting is simple to use. However, it can also be less accurate and present an incorrect view of a company’s finances.
What is accrual accounting? – Companies that utilize accrual accounting recognize economic events when the transaction occurs, not only when cash is paid out or received. Accrual accounting matches revenues to expenses, combining current cash flow with future expected cash flow. This major accounting method is considered standard practice for most businesses, but it can be more complicated. Despite being more expensive to implement and more complex to maintain, accrual accounting provides an accurate picture of a company’s financial condition.
Example: Cash-basis vs. Accrual Accounting – To better understand the two accounting methods, consider the following example. Your company purchases a year-long software subscription, paying the entire subscription cost on January 1.
With cash-basis accounting, the entire expense for the software subscription is recorded when the transaction occurs. On January 1, the full cost of the year-long subscription is recognized as cash paid out. It is not recorded for the rest of the year, even though the software is in use all year.
With accrual accounting, the full cost of the subscription is recorded evenly every month. Even though cash was paid out on January 1, the expenses are recorded over the full term of the software subscription.
How does cash-basis accounting hurt your startup? – Cash-basis accounting is simple to manage, but it provides a limited view of a company’s current financial conditions. The accounting method you choose can impact how you measure your business health and make long-term decisions. By tracking the earn revenues and incurred expenses for your company, accrual accounting provides a clearer picture of your finances.
The more complex accounting method can provide a better foundation for making long-term investments, attracting investors, growing your accounting practices, and setting a realistic budget. Keep reading for the top reasons why cash-basis accounting can hurt your startup.
Skipping Long-term Investments
Startups in early stages make important investment decisions to promote growth. Common financial investments include salaries and people, equipment, and intellectual property. If you do not have a clear understanding of your company’s profit trends over time, you could skip important long-term investments.
While cash flow is important to making large purchases or investments, it is not the final word. By implementing accrual accounting, you can gain a wider perspective of your finances. Decisions on financial investments are better informed, and you can better understand your financial trends.
Deterring Investors
Cash receipts and payments are often uneven, resulting in wide fluctuations in monthly profit and loss statements. The financial results for one quarter may not accurately reflect your annual results, and monthly and quarterly statements may not reflect your true profits. Cash-basis accounting provides limited information to investors, increasing their risk for funding your startup.
If investors cannot review your comprehensive annual financials, including revenue and expenses, they are less likely to partner with you. Long-term trends are less accurate, and it is difficult to determine future profit and burn rate. Investors are left in the dark on outstanding debts, money owed, and the valuable assets for your business.
Using accrual accounting provides the information investors need to confidently partner with your startup. By matching revenue and expenses, you can provide investors with a balance sheet. Potential investors receive a more complete picture of your company, including your strength and potential.
Stunt Accounting Growth
Some businesses are required by the IRS to utilize accrual accounting. Companies that maintain inventory, corporations, and companies with gross receipts more than $25 million per year must use accrual accounting for their finances. Startups that do not meet these requirements can use cash-basis accounting, but your accounting system will have to change when you grow.
Startups are typically focused on growing quickly, and you can outgrow cash-basis accounting much faster than anticipated. Your business is left scrambling to implement a new accounting system, which costs considerable time and money. Using accrual accounting from the beginning ensures your company is prepared to grow.
Unrealistic Budget
In some circumstances, cash-basis accounting can lead to bankruptcy. Budgets can be created using cash-basis accounting without considered future liability. Startups can end up with major cash flow issues if loan repayment is not properly considered over time, investments are not recognized in annual projections, or long-term financial commitments are not considered. Accrual accounting keeps liabilities and loan repayments on your books, so they are always considered when yearly budgets are created.
Establish Accrual Accounting Methods for Your Startup – If you are not sure which accounting method is right for your business or you want to shift from cash-basis accounting to accrual accounting, contact K-38 Consulting today. Our experienced financial consultants work with startups in a variety of industries to implement the best accounting system for each business’ needs.