As a financial consultant at indinero I hear the ins and outs of businesses of all sizes, but more often than anything I talk with smaller startups getting their feet off the ground. I’ve found that the longer I talk to these small business owners, their friendly, informational tone tends to shift into a confession session of all their back-office sins.
The most common blunder I come across is entrepreneurs who chose their accounting method without doing their research. Before a certain growth stage, every business has the option to choose between cash and accrual accounting, but most only make their decision based on two factors: price and effort. This leads them to choose the cash method, which is a great option for some businesses, but can cause a huge mess for others.
Understanding Cash and Accrual/GAAP
If you look through indinero’s blog, you’ll see we’ve written a lot about cash, accrual, and GAAP methods of accounting, but until now we have never actually compared the pros and cons of each method.
Cash Basis Accounting:
The cash method of accounting only reflects transactions at the time payment is actually received or made—basically when cash changes hands.
If a monthly subscription magazine invoices their customers once a year, they’ll recognize the income in full when they receive the lump sum, instead of accounting for it each month when they ship the issue out to readers.
That’s the major upside to cash—it’s super simple:
Pros of Cash: Using this method you can see the exact amount of cash you have available at any given time, and you can account for advanced payments, payments in full at the time they are received instead of over time. So it’s:
- Easy to see cash flow and how much cash a business has on hand
- Cheaper and simpler to manage
- Account for value up front instead of over time
However, if that magazine was to receive all of their income in one month, say December, they may have a difficult time budgeting for fluctuations each month:
Cons of Cash: This is because cash doesn’t make it easy to defer revenue over time. Because of this, you’ll notice the following side effects:
- Limited ability to predict future, long-term profitability which can stifle business growth
- Inability to account for value at the time revenue is earned or activities are performed
- Higher chance for errors
- Not enough insight to anticipate and plan for issues
- Lost sight of opportunities
- Hard to create financial reports for investors, lenders, etc.
- Lack of bandwidth to track things accurately and responsibly
Accrual Basis Accounting:
The accrual method is based on matching, so it allows a business to record revenue and expenses when they are earned in real-time even if payments haven’t hit or left an account. Under this method you can get a better understanding of what a business is worth.
You may have also heard of GAAP or Generally Accepted Accounting Principles, which is the official rules that all accountants, investors, auditors, bankers, and other financial professionals in the United States have accepted and adhere to.
Unlike cash and accrual, GAAP is not a form of accounting but a set of widely accepted standards and rules set in place to ensure companies account for their financials in the same way. Accrual is the acceptable form of accounting under GAAP’s rules. Cash is not.
Going back to our example, if our magazine was to use the accrual method they’d still be able to accept lump sums of annual payments, but would then have the ability to defer (accounting speak for spread or distribute) those funds across the entire year, when they are actually earned. Similarly, any purchases they made would be recognized as spending once the product or service was received or used.
Going GAAP would take this a few steps further. As the magazine popularity grows, its financial responsibilities do as well. Investors, stakeholders, and other potential interested parties will require GAAP-compliant financials to best understand your company.
Pros of Accrual/GAAP:
In addition to adhere to guidelines, the extra attention you give your accounting when using the accrual method or GAAP has plenty of other upsides that help you better understand and run your business:
- More accurate picture of monthly income and spending to help plan ongoing and future activities
- Stronger control over your reported income
- Ability to anticipate cash flow trends
- Accurate budgeting with revenue recognition as the services are performed or received
- Closed loop reporting for tracking expenses and assets back to actual earning potential
- Unbiased picture of your company’s financials–you can see what investors and other outsiders will
- Access to insights that help identify areas for improvement and hidden opportunities
- Intelligence needed to reduce risk or potential mistakes
- Transparency into problem areas–see why you’re not hitting your numbers
Cons of Accrual/GAAP:
Basically, it’s more difficult, takes more time, and costs more money than cash basis accounting. If you don’t have the experience, knowledge, or proper tools to manage the accrual method or adhere to GAAP’s standards there’s potential to make costly mistakes that might be seen as fraud in the eyes on the IRS.
3 ways to tell which accounting method makes sense for your business
Smaller businesses that satisfy the IRS’s restrictions have the choice between cash and accrual methods of accounting and aren’t required to adopt GAAP until they grow to a certain level of revenue or inventory. Determining the right accounting method for your business typically comes down to three factors that affect your business’s financial complexity:
1. Income and Assets Threshold
The IRS uses a Test of Gross Receipts (better known as “the Sales Test”) to ensure companies are under the revenue threshold in order to file taxes using the cash method:
Individuals, sole proprietors, and small business owners (of S Corporations) must have less than $5 million in average annual sales over the last three years. Small business entities (S Corporations and C Corporations) must have less than $10 million in average annual sales over the last three years.
Read more about the Gross Receipts Test on the IRS’s website here.
2. Business milestones
Along with growth in revenue comes a few different business milestones that create a heavier weight on your financials. These include:
- Series A funding rounds
- Third-party auditing
- Investor board meetings/presentations
- IPO (All publicly traded companies are required by law to report their financials using GAAP.)
These milestones require accrual/GAAP to ensure a company is providing objective information investors and outsiders can trust. This also gives outsiders a way easily compare across their other investment opportunities and calculate their potential risk as an investment.
3. Goals for running your business
Do you want to use your accounting to run your business on a financially savvy model? Many business owners eventually realize that managing their money is a great way to actually make more of it. While cash will be easier for most business owners to achieve this without any help, it won’t provide the actual data and insights into company performance accrual will.
Having this handle on projected revenue and spending allows for transparent budgeting, which means you can make more educated decisions earlier on, and makes you a better negotiator when it comes to spending your money.
Cash and accrual aren’t created equal
But neither are businesses. In the long term, most businesses should or will be required to be on accrual, specifically for tax filing purposes. But even smaller businesses who shouldn’t only use pricing to guide their decision. Either way there’s a sacrifice so you have to ask yourself a few simple questions:
Are the extra costs worth it?
Is there potential for the insights you get and the potential mistakes you avoid to pay for themselves eventually?
Or are you okay with the downsides of cash?
If you own a business and have chosen cash accounting, be aware that this method is only as simple as it seems until your business grows and your financial responsibilities get more complex.