Preferred CFO has worked with hundreds of businesses from startups and small businesses to medium-sized businesses or businesses looking to fundraise. While many of these are companies experiencing high levels of growth, many are not yet in a position to afford or justify a full-time, in-house CFO. One of the first things we address with these companies is their accounting method.
Most business startups rely on cash basis accounting, and it’s no wonder why. This method of accounting is not only easier to implement and manage, but it also gives bootstrapped (or cash-strapped) businesses a faster, more clear-cut look at their current cash situation.
However, as a business matures, the company is making a big mistake if it doesn’t transition to accrual basis accounting.
Why Should You Care About Accrual Basis Accounting?
It’s just about when we bring up the idea of accrual basis accounting that founders’ and CEOs’ eyes begin to glaze over. Why compare one accounting method vs. another (snore) when your current method is working “just fine?” Because cash basis accounting provides a limited view of all financial transactions and is not acceptable under GAAP guidelines.
GAAP (Generally Acceptable Accounting Principles) is the standard framework of rules and guidelines that accountants must adhere to when preparing a business’s financial statements in the United States. Under these guidelines, all companies with sales of over $25M must use the accrual method when bookkeeping and reporting their financial performance. This means that if your business were to grow larger than $25M in sales, you would need to update your accounting practices.
If you think your business could exceed $25Min sales in the near future, you might want to consider opting for the accrual accounting method when you’re setting up your accounting system. $25M may seem like a far distant goal for some companies, but growth is the intent of every company—if growth is the expectation, why not have financial statements that conform with current requirements?
Cash Basis Accounting vs. Accrual Basis Accounting
What is the difference between cash basis accounting and accrual basis accounting, and why is making the change so important for companies planning to grow in the future?
Accrual basis accounting is a method of accounting in which revenues and expenses are calculated as they are accrued. This means revenues are counted when the sale is made and earned, even if payment hasn’t been received yet. Expenses are counted when the purchase is made or the bill is received, even if it hasn’t yet been paid.
Conversely, cash basis accounting doesn’t count the money until it sees it exchange hands. This means instead of counting revenue when the sale is made, it isn’t recorded until the money is actually received. If a bill is received, it isn’t recorded until the bill is actually paid.
Further, cash basis accounting does not track long-term liabilities, loans, or inventory, nor does it require your accountant or bookkeeper to keep track of the actual dates corresponding to specific sales or purchases. In other words, there are no records of accounts receivable or accounts payable, which can create difficulties when your company does not receive immediate payment or has outstanding bills.
Why Bother with Making the Switch?
The biggest benefit of switching to accrual basis accounting from cash basis is moving from “hoping for the best” to being able to create a solid, forward-looking financial plan.
Cash basis accounting is similar to living paycheck to paycheck. You may even have budgeting in place, but if you’re being honest, you probably don’t have much more information to go off of than what’s currently in your bank account and how your financial statements say you’re spending money.
This method of accounting can be detrimental to businesses because it doesn’t provide an accurate, realistic view of the financial health of the company. For instance, you may have revenues rolling in from net 60 invoices that you sent out a couple of months ago, but you may not have information in place about accounts receivables and outstanding balances that help you determine what potential cash receipts are expected.
Or you may have several unpaid bills and invoices that make your cash situation look favorable when, in reality, your cash situation will start to look pretty grim when invoices or other financial obligations become due.
Accrual basis accounting empowers you with more information—and a more accurate look at your business. It lets you know not only what cash has exchanged hands, but also what cash to expect, which expenses are upcoming, and what the health of your company (really) looks like as a whole.
Powering a Forward-Looking Strategy
Unlike cash accounting, which provides a clear short-term vision of a company’s financial situation, accrual accounting lets you see a more long-term view of how your company is faring. This is because accrual accounting accurately shows how much money you earned and spent within a specified time period, providing a clearer gauge of when business speeds up and slows down over the course of a business quarter or a full year. Additionally, it conforms to nationally accepted accounting standards. This means that if your business were to grow, its accounting method would not need to change.
Sales terms—for expenses and revenues alike—vary. This means with cash basis accounting you may not record a revenue or expense for weeks or even months after it is incurred. In some situations, the cash exchange for this expense or revenue may not even fall within the same year it was incurred.
However, with accrual basis accounting, expenses and revenues are recorded at the time they are incurred. This matching principle is a fundamental element of accrual-basis accounting. In accrual accounting, a company records revenue in its books as soon as it has done everything necessary to earn that revenue, regardless of when money actually comes in. The matching principle then requires that all expenses required to generate that revenue be recorded at the same time as the revenue. This further empowers the decision makers to more quickly and appropriately assess the profitability of projects.
One of many benefits of this is to inform forecasting, budgeting, and sales strategies. Although this method requires more intensive bookkeeping, it gives business owners a more realistic idea of income and expenses during a certain period of time.
This can provide you (and your accountant) with a better overall understanding of consumer spending habits and allow you to plan better for peak months of operation. With more accurate accrual information, a company can better track sales trends, seasonality, expense patterns, and more. This is especially helpful for forward-looking financial strategies that use data and projections to develop forecasts 1-5 years in the future.
Final Thoughts: Don’t Fight It
Some companies that currently use cash basis accounting fight transitioning to accrual basis. This is because they are accustomed to a rear-facing accounting system where they can see where they are now and where they have been but aren’t accounting for more than what they tangibly have in their accounts. Transitioning to accrual accounting means you are opening up to a forward-facing financial strategy. It gives you a view not only of where you’ve been, but also where you are going.
To those making, or even considering, the transition, it can feel unnerving or even unnecessary to make the change—but once it’s made, you’ll quickly realize the benefits and decision-making power to provides, and that it is worth the switch. Accrual basis accounting not only allows you to see where you are and where you’ve been, but it also gives you an accurate, more informed view of your company’s health and enhances your ability to design and execute more sophisticated and successful strategies in the future.
About the Author
Loren is a financial expert with 15 years in the industry. He is experienced in working in high-growth environments, optimizing financial strategies to help companies achieve their financial goals.
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