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When setting up the books for a new company, most accounting systems make you choose between cash and accrual accounting. This is an important financial decision that founders shouldn’t take lightly, especially if they’re planning to seek outside investment.
The short answer? You probably want to operate your startup’s books using accrual accounting so you don’t have to convert your historical books from cash basis to accrual basis in the future, eating up a lot of time and organizational effort.
Read on to learn more about the differences and why investors favor accrual accounting.
Cash basis vs. accrual accounting
Cash accounting recognizes income or expenses when they are received or paid out, whereas accrual accounting recognizes revenue when it’s actually earned and expenses when they’re actually incurred. It’s tempting to use cash accounting because it’s often simpler, cheaper, and more intuitive.
The accrual method requires additional effort from a bookkeeper, so it can be more expensive upfront and lead founders to choose the cash method.
But …
Converting to the accrual method in the future will be much more costly, and most venture-backed startups will need accrual accounting to meet investor expectations. Some later-stage investors require it, and it’s becoming more common amongst earlier-stage investors, too.
Why do investors prefer accrual accounting?
When comparing financials from one startup to another, investors want metrics that are calculated using a consistent accounting method. Otherwise, these metrics do not allow for useful comparison.
Some people would argue that accrual accounting also provides a truer sense of “business health” than cash accounting because cash collections and payments can be sporadic. Accrual accounting smooths this out to show more consistent trends and predict future financial outcomes.
Plus, if clients, investors, or regulators (like those in the fintech space) require you to get an audit, you’ll need to use accrual accounting. And if there’s a chance (or ambition) that your company will generate $26 million in revenue per year, the IRS will require accruals for tax filings. Down the line, if your startup gets acquired by another company, that company will expect accrual accounting, too.
How can you save money while still filing taxes using accrual accounting?
Early-stage startups can keep their monthly accounting on a cash basis. This is cheaper and more intuitive to record. ****At the end of the year, you can adjust your cash basis financials to the accrual method. Common accrual adjustments include depreciation of assets (like computers), deferred payroll and benefits, deferred revenue (for example, if your customers prepay for a yearly subscription), and prepaid expenses. Rather than calculating and recording these adjustments each month, you can calculate it once a year, as long as the size and number of adjustments are manageable.
What if you want the best of both systems?
With legacy accounting software like Quickbooks, you have to choose cash or accrual accounting, and founders typically want both, because cash is especially relevant to founders. Even if they use accruals for taxes, fundraising, and managing other parts of the business, they will likely want to monitor cash activity. That’s where Puzzle.io can help.
Puzzle is an accounting system built by and for founders and finance teams. The Cash Activity Report shows you your cash, burn, and transaction details as they happen in real-time. You can also get cash basis books and accrual basis books with embedded schedules, for full traceability, auditability, and accuracy. Get started at Puzzle.io.
