Startups can have similar origins – as an entrepreneur or small business owner, you’re passionate about the product or service you provide, you’re excited about how your business could grow, you dream about hiring a great team, having a great office, and so on… but one thing most business owners dread and don’t look forward to is accounting.
You probably won’t be as passionate about accounting and maintaining your financial books as you are about making sales or providing value to your customers. But we’ve got news, maintaining an accurate financial record of your business is critical if you want to scale effectively.
(Don’t know where to start? Read our summary of setting up your startup accounting.)
One of the key things to starting your accounting function is deciding which accounting method to use to record your transactions: cash or accrual accounting.
In this method, a business reports income and expense only when cash is taken or given; so, an expense is accounted only when cash is paid out, and income is recorded only when cash is received. Now don’t let the name ‘cash’ accounting confuse you as it doesn’t have anything to do with the mode of payment transacted. Transactions could be done electronically, but it is recorded only when the funds are received or given.
This method is typically used by personal finances, sole proprietors, small businesses, or businesses with little to no inventory.
Pros of Cash Accounting
1) It’s simple and easy to track
2) It shows the amount of money you have on hand
3) Cash accounting can be beneficial in helping manage cashflow, as with this method you only pay tax on the cash you have received. It doesn’t include invoices issued but remain unpaid.
Please note: Limited liability businesses can use cash-based accounting for filing taxes. For more information, please visit the official IRS website.
Cons of Cash Accounting
1) Cash-based accounting does not show an accurate image of your business’ finance condition, and investors are usually wary of this method because your books may show an increase in cash but you may actually be unprofitable.
2) Since you only get a day-to-day view of finances and not the big picture of amounts to be paid or received, making financial or management decisions may be hampered as you don’t have full visibility or knowledge of your accounts. So, if you’re planning to scale your business, invest in new raw materials, or make other bigger decisions that need you to have full knowledge of your business’s financial situation, you might not make the best-informed decision.
In the accrual-based accounting method, income and expenses are recognized as soon as they are occur. For example, income is reported as soon as an invoice is raised – whether or not payment is received at that moment; and an expense is recognized as soon as a bill is received, even if the payment is to be done later.
This method is typically used by medium sized businesses, publicly traded companies and those requiring compliance with accounting principles.
Pros of Accrual Accounting
1) Accrual based accounting gives an accurate reporting of your business’ finances
2) This method will help you make more informed business decisions and will also be a better pitch for long-term financial investments
Cons of Accrual Accounting
1) It is more cumbersome because you have to track invoices and not just cash transactions
2) You’ll probably be liable to pay tax on the income even before the customer has paid you. However, if the payment doesn’t come through, you can claim a tax credit in the next tax cycle
Choosing between Cash and Accrual Accounting
The core difference in cash versus accrual-based accounting is when a transaction is actually recorded in your books. On a long-term basis it won’t probably affect your books as much – so really choosing one method should be based on ease of maintaining your financial books and immediate business goals in the range of 1-3 years. Do also bear in mind that the IRS requires organizations to use the same method of accounting for a financial year – so you can’t switch between the two mid-year.
If you’re confused about which accounting method you should choose, take into consideration your business goals, your company’s financial requirements, and the resources you have to follow a particular method of accounting. You could also talk to us at Rooled and get our experienced CFOs and experienced controllers to help you in deciding what’s best for your business.