One of the critical decisions startup entrepreneurs must make during the formative period of their business is deciding on the appropriate accounting method to record the economic activity of their company.
With the help of a CFO or similar financially qualified professional, entrepreneurs can choose between two distinct methods of accounting; Cash and Accrual.
Each method offers a different way of recording your company’s economic transactions that can be strategically advantageous depending on your type of business.
Fundamentally, the core difference between the two methodologies rests in the timing of when transactions are recorded.
Here, we examine the basic differences between Cash & Accrual Accounting.
Cash Accounting Method:
The Cash Accounting Methodology demands that the receipts a company receives should be recorded during the period they are received, and that the expenses a company incurs should be recorded in the period in which they are actually paid.
Simply put, revenue is recorded when cash is received, and expenses are recorded when cash is paid.
Accrual Accounting Method:
The Accrual Accounting Methodology demands that any economic event be recorded during the period that it occurs, regardless of when cash changes hand. Accountants who follow the Accrual Method record economic events by matching revenues to expenses in the period when the transaction occurs, rather than when pavement is made or received.
Simply put, revenue is recorded when earned, and expenses are recorded when consumed.
Under the Accrual Method, expenditures can be considered assets if and when they provide future economic benefits to a company. In all other cases, expenditures are considered liabilities recognized when they are incurred.
The accrual method also allows for combining current cash inflows and outflows to be combined with future expected cash inflows and outflows with the objective of providing a more accurate depiction of a company’s current financial condition. In this case, the accrual methodology allows for the use of economic estimates in its financial reporting, which makes the method less precise when compared to the Cash Method.
To better understand the two Accounting methods in practice, and how they account for a company’s revenues and expenses consider the following example:
A company sells $100,000 of coffee mugs to a distributer in March, who pays the invoice a month later in April.
Under the Cash Method, the seller of the mugs recognizes the sale of his goods in April, on the date when he receives payment.
Under the Accrual Method, the seller of mugs recognizes the sale of his goods in March, on the date of when the invoice is issued.
A construction company purchases $50,000 dollar worth of cement in July, which the company pays for a month later August.
Under the Cash Method, the construction company who buys the cement recognizes the purchase of goods in August, on the date when it pays the bill.
Under the Accrual Method, the company recognizes the purchase of goods in July, on the date when it received the cement suppliers invoice.
Pros & Cons
The Cash Accounting Method tends to me a more simple and precise accounting. Income is recorded when cash is actually received, and expenses recored when they are actually paid. The methodology is appropriate for startup companies that have less than $5 million in annual sales, and who do not keep an inventory of merchandise. In this case, inventory also includes any supplies used to create future produce for merchandise. Such business are required by the IRS, no matter their size, to apply the Accrual accounting method.
Without concern for complex transactions such s accruals and deferrals, cash accounting is the easiest method to account for your startups transactions.
While the Cash Method does provide a clear picture of whats in your company’s bank account, it does not provide a accurate picture of your business operative health because it fails to detail completed sales, future or expected revenues and their corresponding expenses.
On the other hand, the Accrual Method of accounting demands greater financial sophistication and suits large companies. First, because it is the required method of accounting and tax reporting when annual sales exceed $5 million, and second, because financial statements can only be audited by the IRS or similar regulatory agencies if they are prepared using the Accrual Method.
Under the Accrual method income and expenses are recorded when they are obligated to be paid, in other words the date of the transaction, not when money changes hand.
Consequently, applying the Accrual Method will more likely produce financial results that accurately match revenues and expenses in the same reporting period, which makes understanding the real profitability of the business easier. However, the accrual method will not do a great job of revealing what cash your company actually has on hand.
Applying this method typically requires the use of accounting software such as Quickbooks.
All business try to reduce their tax burn as much as possible, and generally speaking, the Accrual Method allows for the more flexibility because of the ability to better control when customers are invoiced.
How you elect to determine your periods and taxable year, particularly if you business is a corporation, can also impact how each accounting method affects your company's annual tax burden.
For more information on accounting periods and each reporting methodology, visit IRS Publication 334 on the Internal Revenue Service website.
Startup Accounting Strategy
Startup entrepreneurs, particularly those who come from backgrounds other than finance and accounting, should consider using the Cash Method of accounting. It is a more intuitive and straightforward method of recoding your small business transactions as long as sales do not exceed $5 million.
Once your small business achieves certain economic milestones, entrepreneurs should then quickly adopt the Accrual Method of Accounting and employ the help of talent financial advisors to facilitate the transition.
Some business elect to use a a hybrid accounting method where the accrual method is used to account for inventory, as required by the IRS, while the cash method is used for other income and expense transactions of the business.
To determine the best accounting strategy for your business, and to make sure your company follows United States GAAP (Generally Accepting Accounting Principles), and/or IRFS (International Financial Reporting Standards) seek the guidance of a certified accountant and tax professional.
It is essential to maintain a high level of consistency throughout your accounting practices in order to avoid any potential audit by the IRS. If a decision is made to transition from Cash to Accrual, or vis versa, make sure to properly execute the transition by implementing the right policies and practices.
For more insights on making a transition from Cash to Accrual explore Transitioning From Cash To Accrual. (Coming Soon)
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