There are two primary accounting approaches, the cash method and the accrual method.
Like a16z says, “cash flow is like oxygen for startups…it keeps your business alive.”
This may be true but the cash method of accounting is not always the most useful, or the most compliant.
The two different approaches to bookkeeping dictate how a company records and reports their income and expenses:
- When revenue was received and expenses paid for, or
- When revenue was earned and expenses incurred
It’s all about timing.
Accrual basis vs. cash basis accounting: what's the difference?
Cash basis of accounting
When a company incurs an expense, it’s recorded as an expense. When a company receives money in its bank account, it’s recorded as revenue! Easy! Revenue is recorded as revenue if a company receives payment for that revenue, regardless if that revenue was earned. Expenses are recorded in the period that they were spent, not incurred.
Accrual basis of accounting
This is all about matching. Revenue is recorded as revenue if that company earns it in a given period, regardless if cash payment was received in that period. Expenses are recorded in the period that they were incurred, not spent.
Typically, business owners have the autonomy to choose the accounting method that best suits their needs, up to a certain point.
The accounting method a startup chooses is important because it will:
- Determine tax liabilities
- Helps the company stakeholders understand the financial health of the business, guide cash management decisions, and financing decisions
- Influence decisions for investors and lenders
After a company has made its selection, the IRS requires the company to stick with the chosen method for the entire tax year.
Because of its simplicity, many small businesses and startups opt for the cash method! But the cash method only works for so long until accrual accounting becomes more important, or even essential. In fact, 67% of startups use accrual basis accounting!
Why startups choose accrual basis accounting
It’s the law
The IRS and other regulations prevent certain startups from using the cash method. For example, publicly traded companies must follow Generally Accepted Accounting Principles (GAAP), which dictates that accrual revenue must be used. This is why most CPAs and accounting firms use accrual basis accounting. As of 2020, companies with average annual gross receipts of $26 million or less can select either method. If a company’s average gross receipts are higher than $26 million over a three-year period, they must use the accrual method of accounting.
For investors
Some investors may ask for GAAP compliant financial reports or require the company to switch accounting methods if there is a plan to go public. Investors will often ask for accrual basis financials as this is a consistent, fair way to compare financial performance across different companies they may be considering as investments. Accrual basis revenue also gives a clearer picture on how a SaaS company earns revenue over time. When revenue is accurately recognized as it's earned over time, it tends to exhibit less month-to-month volatility, creating an impression of stability and predictability.
For loans
Traditional financial institutions will also seek out accrual based financials statements when assessing loan applications.
Switching accounting methods can be quite an undertaking! This is precisely why some companies choose to embrace accrual accounting right from the start. Determining the ideal moment for this transition can be a challenge since accrual accounting can impose additional responsibilities on the individuals managing financial records. It's still often a popular decision to proactively plan ahead and get a head start whenever feasible.
How to record revenue under cash basis accounting versus accrual basis accounting
Let's use Puzzle as an example.
A customer paying for an annual 12-month Puzzle subscription upfront sounds awesome.
But its interpretation could be misleading. Seeing 12 months of cash revenue upfront might signal to an investor or a lender that Puzzle has higher revenues than it actually does. Under the accrual basis of accounting, companies cannot record the 12 months of cash revenue as revenue until the services have been rendered.
Under an annual 12-month subscription, Puzzle must deliver one month of services to this customer (the right to use its platform). Every month, Puzzle can recognize 1/12 of this upfront payment as revenue on its income statement. The remaining of amount is considered deferred revenue and is recorded as a liability account on the balance sheet. It is amortized (decreased) every month to account for the revenue Puzzle actually earned.
This process works the same way for any subscription duration, even if the service started mid month.
There are also cases where revenue may be earned, but not yet paid for by the customer. Revenue would be recognized on the income statement in the month it was earned, with a corresponding balance in accounts receivable.
How to record expenses under cash basis accounting versus accrual basis accounting
Paying for an expense where the service has not yet been used or rendered is considered a prepaid expense. No expense would be recorded in the income statement in this case.
When expenditures are rendered and used, but not yet paid for, an accrued expense is recorded in the income statement. An accounts payable balance is also accrued for, representing the amount still to be owed to the vendor.
Puzzle: Accrual basis and cash basis financial statements
Why pick just 2? Run dual-basis cash and accrual-based financial statements easily with Puzzle. The bonus? Automate revenue recognition with auto-generated deferred revenue schedules and auto-recognition entries in Puzzle.
Puzzle also gives startup founders who need startup metrics like MRR (monthly recurring revenue), ARR (annual recurring revenue), and automated revenue recognition, an easy way to access this.
Knowing the most appropriate way to record transactions, record income, and record expenses is one of the first financial decisions an entrepreneur should make. There are benefits to the cash and accrual method. Companies should select the method that is best for their income tax and business situation. The cash method helps with short-term cash planning and forecasting, while accrual basis accounting may be necessary for tax purposes and having a better understanding of the company’s financial position.
Get both simultaneous accrual basis and cash basis financial statements with Puzzle.
