- Cash basis accounting is simple and logical, but only appropriate for very small businesses and sole proprietorships
- Accrual basis accounting is more complicated, but also more accurate and informative. It is highly recommended for any company that is raising capital from investors (debt or equity)
- Accrual accounting is required by the IRS once you cross $25M in annual gross receipts (revenue plus interest income). Until that point, founders and investors are allowed to choose the accounting methodology they prefer
Accrual accounting involves tracking business activity, not just transactions. Under this methodology, revenue and expenses are recorded when the corresponding activity occurs, regardless of when the money is actually received or paid. Accrual accounting provides a more accurate view of a company’s health, as it removes the wild fluctuations that can occur due to payment timing.
Examples of relevant accrual accounting practices:
- Recognizing revenue on your P&L when a service/product is delivered, even if you haven’t been paid for it yet. Or, in the case of SaaS companies, recognizing revenue each month when a customer pays for their annual license upfront.
- Expensing a large pre-paid transaction over multiple months (i.e., if you pay $12,000 for a year of business insurance, your P&L would show $1,000 of insurance costs each month).
Depreciating assets like vehicles, buildings, and equipment so your P&L shows small monthly expenses for these items rather than large upfront costs.
Cash accounting, on the other hand, involves recording only the payments you receive or make. Revenue is recorded when a customer pays you, and expenses are recorded when you pay a vendor. Many sole proprietors, smaller businesses, and brand-new startups use cash accounting methodology, as it’s very easy to track and understand.
Key drawbacks of cash accounting:
- Revenue will fluctuate month-to-month based on payment timing, which makes it tricky to know your MRR/ARR and understand your true growth rate.
- Expenses will similarly fluctuate month-to-month, especially when you invest in hard assets (vehicles, equipment, etc.) or pay upfront for things like insurance. This makes it difficult to know your true burn rate and anticipate the future cash needs of the business.
- As you scale, it will become more difficult to keep track of which customers owe you money, and which vendors you owe money to. Accounts receivable and accounts payable are not tracked under cash methodology.
Some organizations must use the accrual methodology for their annual income tax filings, so cash basis bookkeeping can create more work around tax season. If you’re able to file taxes on a cash basis, you may find that your tax bills fluctuate wildly based on the timing of payments.
Pros and Cons of Each Methodology
- Clear look at immediate cash flow
- Easier to reconcile books and avoid errors
- A simpler method with less of a learning curve for founders who want to DIY (which we don’t recommend)
- Inaccurate picture of long-term business trends
- Most investors prefer accrual basis accounting
- Not be acceptable for tax purposes if exceed $25m in annual gross receipts
- More accurate picture of long-term financial health and trends
- Fully compliant and consistent with GAAP / IFRS standards
- Preferred by most investors and the IRS
- More difficult and time-consuming for founders who wish to DIY (again, not recommended)
- Cashflow is tougher to decipher if you don’t know how to read all three major financial statements
- You will likely pay more for monthly accounting support, as it takes more time and expertise to do things the right way
So Which Basis is Best For Your Startup?
Both methods have their advantages and disadvantages, but most companies should switch to an accrual basis as soon as they can afford to do so. It is superior from a tax/compliance standpoint and more informative for management and investors.
Some companies will also use a “Modified Cash Basis” or “Modified Accrual Basis” accounting methodology, where certain types of revenue/expenses are booked on an accrual basis while others are booked on a cash basis. An example of this would be booking payroll on a cash basis (rather than accruing it based on the number of days in a month), while still tracking accounts receivable. This again is not consistent with GAAP and IFRS standards, and is generally inferior to a true accrual basis in most cases.
If any of the following is true for your business, you should definitely use accrual accounting:
- You are backed by institutional investors (like VCs), or plan on seeking funding from investors
- You own assets like vehicles, property, and equipment
- You are scaling and hope to “exit” by selling your business or going public
If you fall into the below category, cash basis or “modified cash basis” accounting may work just fine:
- You are running a “lifestyle business” and don’t plan on exiting (via M&A or IPO), raising investment capital, or applying for loans
- You and your business partners are more concerned with cash flow (keeping the lights on, taking payment draws, etc.) than long-term business trends
- You have a good handle on the general trajectory and health of your business without looking at monthly financial trends