As a startup founder, you need the right financial data in order to make decisions that put you in a position for growth. The right financial information will help you understand your investments, build a financial forecast, and plan for future funding raises. In order to get this information and really understand how you’re performing, you need accounting that looks forward––aka accrual accounting.
Accrual accounting is the most accurate, useful, flexible, and shrewd accounting method. So why do so many businesses neglect to use it?
One reason is that for non-finance people, the term “accrual accounting” is perhaps the most boring combination of two words in the English language, and explanations of what it is and how it works tend to be equally tedious. With that in mind, I’m going to explain accrual accounting through a decidedly not dull example.
What Is The Best Accounting Method For Your Business?
Imagine you’re an entrepreneur, and you just launched a mobile subscription app for monthly clown wigs - your take on Stichfix for wigs. We’ll call it, um, Wigsfix. After months of research, experimentation, product development, fundraising, and marketing, Wigsfix has its first subscriber—and it’s a big one. You’ll be shipping 24 boxes of clown wigs to the Monterey Bay Clown Company, for a grand total of $430,052.71 (this is, after all, highly advanced technology, and it carries a premium).
Now here comes the accounting part. On recommendation from your financial department, you’re using Net 30 invoices, meaning each customer has 30 days after receiving an invoice to pay it. Do you…
- …wait to record your revenue until the check from the Monterey Bay Clown Company shows up and gets deposited into the company’s bank account?
- …go ahead and record the $430,052.71 now and mark it as “paid” when it arrives?
In other words, when should Wigsfix actually see the money?
If you wait until you can cash the check to record the money in your books, you’d be using what accountants call the cash accounting (or cash basis accounting) method. Cash accounting is simple—you recognize cash as it comes in and goes out. You can only look back; any pending transactions don’t count as far as your books are concerned.
If you record the revenue now, you’d be engaging in accrual accounting. In an accrual-based accounting system, the company’s financial department generates a receivable entry (indicating an amount due) whenever an invoice is sent out, and then adjusts the receivable to zero when the payment hits the company’s accounts.
Virtually every business starts with cash accounting, and many stick with it. But if you’ve recently undergone a period of substantial growth or reached a major financial milestone (such as, say, selling 24 boxes of clown wigs to the Monterey Bay Clown Company), you may want to consider switching to accrual accounting. Why? Because unlike the cash method, the accrual method allows you to look forward. You can predict and track revenue and expenses ahead of time.
This ability to look forward and backward has numerous benefits—here are just a few:
Improve Your Business Analysis, Planning, and Forecasting
When you match expenses and revenue through accrual accounting, you’re representing your business’s finances more realistically—and it’s not just the IRS who should care about that. You’ll also give your executive team a better operational understanding of your company’s books, improving your ability to analyze your organization’s current and future financial health.
Accrual accounting gives you real-time visibility into your business strategy. When you account for income as you earn it instead of waiting to receive cash, you’re forced to see whether you’re meeting your goals and expectations down to the month, day, or minute. If Wigsfix needs to earn a quarter of a million dollars each quarter to fund its R&D program, the company knows that it doesn’t need to wait until the payment from the Clown Company arrives to start the wig-making up again.
On top of that, you can budget faster and more strategically. By tracking not only what you have, but also what’s coming in and going out, you’re less likely to let things fall by the wayside or make plans while overlooking relevant transactions that haven’t been paid for. A payment for 12 months of wig shipments may look like a windfall in the short-term, but if it equals only a few thousand per month, Wigsfix is going to need to find some more customers.
Your Potential Tax Advantages With Accrual Accounting
By using accrual accounting, you could claim expenses on the tax form for the year you incur those expenses, rather than in the year you actually pay them. If you owe another party now, you don’t need to wait until you settle your debt to deduct it from your taxes.
Additionally, your business can postpone paying taxes on any income paid in advance for future products or services—up to the next tax year. This pile of money, which your company possesses but has not totally earned yet, is called deferred revenue, and it can help a business out during tax time.
Thinking back to our example, if the Clown Company paid upfront for an annual subscription of monthly of clown wig shipments, Wigsfix could—via accrual accounting—recognize the money as deferred revenue and record it as a liability. As Wigsfix delivers each shipment over the course of the year, the company would convert that chunk of deferred revenue liability into plain old revenue.
Let’s say your company entered into a similar contract, and your fiscal year starts on July 1st rather than January 1st. With accrual accounting, you may be able to save money on taxes by deferring half of the revenue you possess now until next year while deducting your present-day expenses (which you may or may not have paid yet) in the current fiscal year.
Don’t Forget: Accrual Accounting Is Required for GAAP Compliance
Finally, I should mention that accrual accounting is a core element of Generally Accepted Accounting Principles (GAAP). All publicly traded businesses must comply with GAAP, but any private company probably should as well if it’s intending to go public, courting investors, applying for a loan, or in the midst of virtually any activity that may reveal its books to an outside party.
Timing Is Everything When Switching Your Accounting Method
The difference between cash and accrual accounting is all about timing, and so is the decision to switch from one to the other. Don’t rush into it. Be sure to seek advice about when and how to adopt accrual accounting before you change your system. If you switch too early or too late, you could lose out on tax benefits and wind up on the hook for payments you can’t afford.
Don’t switch if your business is small and pre-revenue, or not yet profitable. Are you making money? Do you expect to be making money soon? If not, stick with cash accounting—the accrual method could add unnecessary complexity to your business.
Do consider switching if…
- Your business is profitable or you’re planning on being profitable in the next 3-6 months. Accrual accounting will help you maximize your profit and minimize your liability.
- You already have accounts receivable and accounts payable but are not necessarily tracking these processes. In other words, if you’re already treating money invoiced as money earned, and money promised and money spent, you should probably standardize things with accrual accounting. (Don’t take on more expenses managing your accounts: a tool such as inDinero’s Full-Service Bill Pay can help you meet your AP needs.)
- You keep inventory. Sitting on boxes of wigs? It’s time to switch—the IRS generally requires businesses with inventory to use cash accounting.
- Your fiscal year is about to end. The best time to make the switch is at the end of your fiscal year. That means that if your financial year coincides with the calendar year, you should think about making the switch so it becomes effective January 1st. Switching after a year has begun is a recipe for a migraine, given all the paperwork, reporting, personnel changes, and so on—you’ll need to file twice as many forms and hire a backend accounting provider, all while you’re in the middle of running your business.
Now that you’re familiar with accrual versus cash accounting, do you know which one is right for you? If you’re an inDinero client, you already have the resources to answer the question! If you’re not, download our free business owner’s guide to GAAP, which includes lots of information about accrual accounting. And no clowning around—when you’re ready to make the switch, we’re here to help.