Why Cash-Basis Accounting Could End up Sinking Your Startup
When it comes to growing a startup, most entrepreneurs are laser-focused on growth, but aren’t always aware of the nitty-gritty details of business accounting methods. That’s not really a surprise: an experiment by the Business Literary Institute found that entrepreneurs scored an average 20% on financial literacy tests. For startup founders, finances can be an afterthought to bigger ideas and problems they are grappling with.
But accounting is actually tightly tied to growth. A deep understanding of a company’s numbers can help entrepreneurs make better decisions about growth, ad spend, marketing, and hiring. One of the many financial decisions founders have to make is which accounting method to use: cash-basis or accrual.
While there are pros and cons to each approach, the bottom line is that cash-basis accounting can limit your view of the financial health of your business. That can be particularly painful to fast-growing startups seeking funding. In this post, we’ll cover four scenarios where cash-basis accounting can be problematic and explain how to navigate those situations.
Cash-basis vs Accrual Accounting: A Quick Overview
Cash-basis accounting recognizes revenue and expenses based on cash inflows and outflows. If you were using the cash-basis method, you would record an expense when you paid a bill, even though that might not necessarily be the same time that you incurred the expense.
Cash-basis Example:
You prepaid for a software subscription for the year on January 1. Then you record this expense in the ledger in full on the day you paid for it (January 1). You would not record anything else for this expense for the rest of the year, even though the software is still being used.
Accrual accounting, on the other hand, ignores cash inflows and outflows. Instead, the accrual method tracks earned revenues and incurred expenses. Accrual accounting can often provide a clearer picture of overall business health.
Accrual Example:
You prepaid for a software subscription for the year on January 1. You would record this expense evenly every month over the term of the subscription period (one year in this case).
How Cash and Accrual Accounting Affect Your Bottom Line
These might seem like formalities, but accounting methods can alter how you measure the health of your business. Let’s take a closer look at how each accounting method affects the bottom line.
The scenario
Let’s say your business completes the following three transactions during the month of March:
- You invoice a customer $5,000 for services your company provided.
- You receive an invoice for $2,000 from a vendor for repair services. The invoice is due in 30 days.
- A customer pays you $500 for an invoice you gave them in February.
Here’s what you would record in your books for March, using cash-basis accounting:
- No accounting entry, because no cash has been received for the sale.
- No accounting entry, because no cash has been paid for the repair services.
- Increase the cash account by $500, and post revenue of $500.
You’ve completed three transactions this month, but only recorded info on your books about one of them. This could leave you with an incomplete picture of where your business stands.
How accrual accounting would have changed your view
The accrual method posts revenue when goods are shipped and records an expense when services are provided. Revenue and expenses are posted, regardless of cash inflows and outflows.
Here’s what you would record in your books for the above three transactions, using accrual-basis accounting:
- Increase accounts receivable and increase revenue $5,000 for the products shipped to the customer.
- Increase repair expense account and increase accounts payable $2,000.
- Reduce accounts receivable and increase the cash account $500 for payment of the customer invoice.
It’s obvious even from these simple examples that the accounting method you choose has an impact on how you view your startup’s financial situation. Take a look at the following four scenarios to further explore the benefits of accrual accounting for fast-growing startups.
Scenario 1: You Need to Invest in Long-Term Assets, But You Don’t Want to Jeopardize Profits
Growth demands financial investment. That’s particularly true of early-stage startups, but also for later-stage endeavors. Founders have to be willing to invest in long-term assets like people, equipment, and intellectual property. To do that, they have to understand profit trends over time. Cash-basis accounting can make that hard to do. Let’s take a look at how that happens.
The scenario
During the month of March, your startup:
- Paid $12,000 for an annual business insurance premium.
- Made a sale worth $30,000 and invoiced the customer in March. You received $10,000 in cash from the customer in March. They will pay you another $20,000 in 90 days.
Using the cash-basis method, you:
- Record an expense of $12,000 for the business insurance premium.
- Record revenue of $10,000 for the customer payment. You don’t record anything for the $20,000 receivable.
Your books for the month of March using the cash-basis method reflect a loss of $2,000. Based on this picture you may decide to forgo spending on longer term investments right now.
How accrual accounting would have changed your view
Here is the same scenario with accrual accounting:
- Record $1,000 of expense for the insurance premium in March and $11,000 prepaid on the balance sheet.
- Record $30,000 in revenue for the sale. Note that your balance sheet would still reflect that you have $20,000 in receivables outstanding.
Your books for the month of March using this method reflect a profit $29,000.
A positive bottom line of $29,000 shows the health of your business and opens the door to investing in long-term assets. Of course, you should still be keeping an eye on cash flow to make sure your business stays healthy and solvent.
As you can see, accrual accounting in this case allows you to take a wider perspective on your company’s financial situation and make more informed decisions.
Scenario 2: Investors Don’t Want to Fund You
Investors want to see the performance of your business over time. They do that by analyzing things like operating margin and profit margin. They use that information — along with market analysis — to project future profits and decide if you’re a solid investment. Here’s your second scenario:
The scenario
You head into an investor pitch meeting, armed with your accounting ledger prepared with the cash-basis method. The VCs ask to see your company’s financials over the last year. Using cash-basis accounting, you present your revenues and expenses, and show you recorded a profit for the past twelve months on your income statement.
You may think this is all the info they need to hear — time to get funded! Unfortunately this info doesn’t tell investors everything they need to know. They can’t tell whether your business has debts, is owed money by clients, or has valuable assets. You’ve told them the money you have in your pocket, but that’s all.
On a broader scale, cash-basis accounting may generate wider fluctuations in monthly profit and loss, because of the uneven nature of cash receipts and payments. That means that the results for the quarter probably won’t be representative of annual results and won’t truly reflect profits. Without more info, investors can’t get a feel for longer-term trends, and therefore can’t extrapolate on future profit or burn rate.
How accrual-basis accounting would have changed your view
Accrual accounting allows you to show investors the info they need to evaluate investment risk. Using the accrual method, your firm matches revenue earned with expenses incurred to generate that revenue. The accrual method also provides a balance sheet, which shows future cash collection and debts. This is a more complete picture for investors looking to evaluate your business.
Reliable, verifiable profits allow investors to judge the business’s capacity for operating with a higher level of debt. If you can generate sufficient earnings, you can manage the repayment of principal and interest on debt. This is a good indicator of the strength of a business as an investment.
If you are planning to look for angel or VC investment, you must start using accrual accounting a few months prior so you can generate a body of financial statements. This will give you time to establish proper accounting processes and software, organize your books and have everything you need to seek funding.
Scenario 3: You grow…and your accounting method can’t grow with you
The IRS cares what type of accounting method certain business entities use. There are a few caveats, but basically you have to use accrual accounting if your business maintains inventory, is a corporation, or has gross receipts over $5M per year.
If your startup doesn’t meet these conditions, it’s not a legal issue if you want to use cash-basis accounting. But if it does grow to meet them, then you’ve got to change your accounting system.
The scenario
Imagine your startup has gross receipts of only $1M annually, has no inventory, and is not a corporation. You decide that cash-basis accounting will be best because it allows you to control income flow by delaying when you invoice, or by paying expenses more quickly than normal.
This means you can get deductions earlier or defer paying tax on revenue until the next tax year. You don’t have this flexibility with accrual accounting.
But over the next twelve months, you make $5M in gross receipts. That’s great for business. But you are now legally obligated to implement accrual accounting. And if you’ve previously filed taxes using the cash-basis method, you’ll have to apply to change using Form 3115.
How accrual accounting would have changed things
Changing accounting methods ends up costing money in accounting services, and it could mean overhauling how your startup processes payments and files taxes. Accrual accounting can be used for every type of business, so it’s flexible no matter what your situation is. If you plan to grow, it’s smart to implement an accounting method that will grow with you.
Scenario 4: You Need to Build a Realistic Budget
Using cash-basis accounting, it’s possible for founders to project future spending without considering long-term financial commitments. For example, founders could plan to buy a large asset on credit and not recognize the cost in an annual budget projection. It’s this kind of activity that helped bankrupt the city of Detroit in 2014. Let’s take a look at the potential impact on a startup.
The scenario
Assume that your startup gets a line of credit from your bank for $50,000. You get all of the money upfront, and you must pay it back in three years.
Using cash-basis accounting, the financial statements at the end of year one don’t list a liability to pay the loan because you don’t have to pay the loan in year one.
If you’re not being careful, this makes it possible to build a budget for future years without taking that future liability into account. But when year three comes around, if you have failed to put money aside for the loan repayment, you could be looking at a big cash flow problem.
How accrual accounting would have changed your view
Accrual accounting would require you to create a liability account for the loan repayment. It would always be on your books, so you wouldn’t be able to overlook it as you created your yearly budgets.
Moving Forward with Better Financial Management
Accrual accounting is the key to separating the cash in your pocket from the overall financial health of your business. While you need cash in the bank to pay monthly bills, you also need a wider perspective of profit, loss, and liabilities.
The distinction between the two accounting methods may look like splitting hairs at first. It’s easy to assume that cash in the bank is the same as profit.
But understanding when you’ve truly earned revenue allows you to position yourself for stronger, faster growth. If you know the broader financial situation of your business, you’re able to invest confidently, borrow more, and take smarter risks, all based off of sound financial foundations.
Quick disclaimer: At Pilot, we are a team of startup finance enthusiasts, not lawyers, financial advisors, CPAs, or tax preparers. This article is provided for informational purposes only, and it is not legal advice, accounting advice, or tax advice. You should always consult a licensed accountant, lawyer or other appropriate professional for advice on your specific situation.