Why Your Startup Should Use Accrual Instead of Cash Basis Accounting
Recording the value of business activities as they happen — not just when money changes hands — will help clarify where your finances stand.
In business, attention to detail often spells the difference between success and failure. It's critical to know your numbers inside and out, particularly at a high-growth startup that's hustling to win against the competition and achieve sustained profitability.
You might not think it matters whether you use the cash or accrual-based accounting methodology. Cash basis is easier — and as long as all the money gets counted, the bottom line is the same, right?
Not necessarily. Here's why.
Timing really is everything
The key difference between cash and accrual accounting lies in the timing of when transactions are recorded.
On a cash basis, accounting transactions are simply recorded when money changes hands — in other words, when cash is received or deducted from the company's bank account.
In contrast, accrual-basis accounting records transactions when they are incurred in the real world, regardless of whether cash payments have been made or received yet.
To understand why accrual accounting is more prudent for your business, consider this hypothetical scenario:
Your startup’s burn rate is tracking at $10K per month and it has $60K cash in the bank at the end of June. Your startup attorney sends you a $20k bill on July 5th for some legal work they just performed for your business in June.
Using accrual-basis accounting, you'd record that legal bill as an expense in the month of June, even though you haven't actually paid the bill yet. So your income statement (also referred to as your profit and loss statement, or “P&L” for short) would reflect the extra $20K expense that pertained to your business activities in June. You'd also have a $20K liability on your balance sheet, indicating you still owe $20K to your attorney.
In other words, your financial statements would make it obvious that $20K of your bank balance is already spoken for (in order to pay your attorney.) That would leave $40K cash available to cover your burn, giving you a four-month runway. Bottom line: You have enough cash to carry you through October.
In contrast, cash-basis accounting doesn't document the transaction until money actually changes hands. So you wouldn't record the $20K liability due your attorney on June's balance sheet — nor would you record the $20K expense on June's P&L.
Technically, you'd still have $60K cash in the bank at the end of June. But since the $20K legal bill won't be recorded in your books until you actually pay it, your company financials would imply you still had six months of runway at that $10K per month burn rate. That, in turn, could lead you to believe, mistakenly, that you won’t run out of money until year's end. But after you finally pay that $20K legal bill in August, you'd read your cash-basis financial reports in the middle of September and suddenly realize you have only a month and a half of runway left.
Surprise!
That's an over-simplified example, of course. Still, the point is clear: Because cash-basis accounting only tells part of the story, it often breeds confusion and misguided decisions.
And while cash-basis bookkeeping might seem cheaper and easier than accrual-basis bookkeeping, it leaves an extra volume of work to keep track of unpaid liabilities and other non-cash activities in the back of someone's mind or buried in a pile of paper or a random spreadsheet. Failure to keep tabs on those unpaid expenses in the books creates a false picture of your company's financial performance — and the potential for more nasty surprises when those unpaid expenses suddenly come due.
Accrual-based accounting also helps with monitoring other debts
Credit card spending is another example of how accrual-basis accounting provides a more accurate picture of your company's financial position. Let's look at another hypothetical scenario.
In addition to effectively borrowing $20K from your attorney between June and August, your startup buys $20K worth of lab supplies in June using a credit card — but again, you don't pay off that debt until August.
Accrual-basis accounting would precisely show the expense and corresponding liability in June, followed by the reduction to cash (and corresponding reduction in liability) when the debt is paid off in August.
Cash-basis accounting would delay recording the expense until August, potentially obscuring management's visibility into (or memory of) what happened in the business during June.
Interest expense on convertible notes should also be recorded as an accrual-basis expense on a startup's P&L, with the other side of the entry increasing your liability on the note. That's because the startup eventually either needs to repay the principal plus interest to the investor or convert that debt into equity.
If you maintain your company’s books on a cash basis and don't accrue the interest expense, you'll have a hard time accurately calculating dilution from your next planned capital raise. That would be another one of those nasty surprises for both you and potentially a lot of other people. It might even kill the investment deal altogether.
Revenue and cost recognition
If your business sells products (through ecommerce distributors, or wholesale channels), cash basis accounting can be very misleading with regard to your profitability. Let’s imagine it costs you $5 to purchase or manufacture each unit and you eventually sell each item for $9. If you purchased 1,000 units in December and recorded the cost as an expense on your P&L when the cash left your bank account, last year’s cash basis reports would present the $5,000 expense as a loss. Then if you sold 100 units and collected payment from your customer(s) in January, your cash basis P&L would report the $900 income without considering the cost you previously paid last year to source the product. That might give you a false sense of confidence to increase spending in other areas faster than your true profits can support.
In reality, when you spend money to procure inventory you’re actually trading one asset (cash) for another asset (inventory) but you haven’t actually incurred any expense yet — accrual basis accounting would effectively treat that first transaction as a $5,000 investment of your cash into $5,000 worth of inventory, both of which are listed as assets on your balance sheet. Then when you sold 100 units in January and collected the $9/unit payment from customers, your accrual basis P&L would report both the $900 as revenue and the $500 as expense — accurately reflecting your true $400 profit earned in January. At the same time, you no longer own 100 units of inventory after fulfilling your customer orders, so the inventory asset value on your balance sheet would be reduced by $500, leaving $4,500 worth of inventory value that you still own. Payment terms with your suppliers, sales taxes, timing differences between when you receive payment from your customer vs when you actually deliver the product to them, and other factors all cause other variances between cash basis and accrual basis financial reporting.
Many subscription-based companies (like SaaS and subscription box businesses, for example) collect up-front payments from their customers that cover multiple months of software license fees or product shipments. Some of the same principles above apply, where accrual basis accounting more clearly and accurately report revenues and corresponding costs on the P&L in each month, even though cash may change hands at very different time intervals. Those companies may also need to keep track of the liability they owe to their customers when accepting prepayments months in advance of when they eventually deliver the product or service they’ve promised under contract.
Prepaid gift cards and invoice factoring are other areas where cash basis accounting can create dangerous profitability and cash flow blind spots for some businesses.
Creating an auditable paper trail
Research grants, which are common among life science and biotech startups, are another potential problem area for cash-basis bookkeeping. Government grant awards often come with reporting requirements, audit rights and drawdown schedules.
Accrual-basis bookkeeping is much better suited to helping grant recipients stay in compliance with these requirements. The grantor expects recipients to accurately report on program spending against what's in the grant budget and for drawdown requests to closely align with the budget and timing of when the cash is spent.
If you draw down too much too fast, you might be required to pay the money back — plus interest. Miss a drawdown deadline, and you might never receive those funds at all. And if your financial reports are inaccurate or incomplete come audit time, you'll find yourself in a very uncomfortable position. Why? Let's just say nobody wants to be on the wrong side of a compliance issue with the U.S. government.
Properly accounting for expenses on an accrual basis not only creates an auditable paper trail of program costs, but also helps you plan drawdown requests to align with the grant schedule and your quantifiable upcoming cash spending needs.
Do you have a financial forecast?
It's a common rookie mistake to represent forecasted income and expenses on a cash basis without also modeling the balance sheet and cash flow statements. A simple cash-basis forecast might work for very early-stage startups that are just burning cash at a controlled pace, but you'll have a really hard time getting your actuals to line up with the forecast.
Aligning both your actuals and forecast on accrual methodology can help you recognize patterns based on historical transaction activity and then forecast future cash flow with a higher degree of accuracy and confidence.
Planning to raise capital or be acquired?
Investors, banks and strategic acquirers need to understand what they're buying. Those folks won't have confidence in your numbers if you present them with cash-basis financial reports that don't tell the whole story — and that can delay or even kill the deal. They may also lose confidence in you as an investable CEO because it indicates your lack of financial accountability and insight.
It's all too common for startups to scramble at the 11th hour to "recreate the truth" by redoing several years' worth of historical accounting on an accrual basis while their would-be investors grow impatient. In addition to being incredibly stressful for everyone involved, that can make it difficult to achieve accurate results. Re-cooking the books is also a duplication of effort that costs precious dollars at a time when you may not have much runway left. You've also missed out on all the value and insights that accrual-basis financials could have delivered to you along the way. Worse yet, the delays and related optics may also result in a lower valuation.
Cash-basis accounting still has its (very limited) place
So is cash-basis accounting ever appropriate in the business world? Yes, actually. Most small businesses, including the vast majority of early-stage startups, are able to file income tax returns on a cash basis, even while maintaining their books and making informed business decisions on an accrual basis.
But for all of the reasons described above, and plenty more, accrual-basis accounting is the gold standard for professionally managed and investor-backed businesses that follow generally accepted accounting principles (GAAP). Consequently, that's what venture investors expect to see before they write a check.
Running a startup is hard enough as it is. Don't shoot yourself in the foot by trying to cut corners on bookkeeping best practices. As always, you get what you pay for.
