Cash vs. accrual accounting: Which is best for startups?
The cash method and the accrual method are the two primary accounting options for recording and reporting a company’s income and expenses. In most cases, business owners get to decide which method they’ll use.
As a startup founder, you need to make this decision carefully because it has a significant impact on your company’s future. Your accounting method determines everything from your profit and loss reporting to your tax obligations. It can help guide your business strategy or leave you open to cash flow miscalculations. The method you choose can even affect your prospects with investors and lenders.
Keep in mind that once you’ve made your choice, the IRS requires you to use the same method for the rest of the tax year. So it’s important to choose an option you’ll be confident using for the long run. We’re here to help you to make the right choice — and one you can comfortably stick with. Here is everything you need to know in the cash vs. accrual method debate.
Overview: Cash vs. accrual accounting method.
The difference between cash-basis accounting and accrual-basis accounting comes down to timing. Each method has different rules about when businesses have to record their revenue and expenses.
Using the cash method, you record revenue when you receive payment, and you record expenses when you pay for them. This is how most people track their personal finances.
Using the accrual method, you record revenue when the sale occurs, and you record expenses when you receive the goods or services — regardless of when payment is received or sent. In other words, you don’t wait to see money change hands before you record the transaction.
Because of its simplicity, cash-basis accounting is a go-to method for startups with 10 or fewer employees. However, the majority of startups (67%) use accrual-basis accounting to track and report their transactions. IRS laws and other regulations prevent some startups from using the cash method.
Which businesses are allowed to choose their accounting method?
Most early-stage startups are free to adopt the cash or accrual method.
As of 2020, companies with average annual gross receipts of $26 million or less are eligible for either accounting method. The IRS refers to this as the “gross receipts test.” Prior to the Tax Cuts and Jobs Act, the annual sales threshold to use the cash method was only $5 million. If a company’s average gross receipts exceed $26 million over a three-year period, they must use the accrual method of accounting.
And there are other reasons your startup may need to use this method sooner or later. For example, publicly traded companies have to follow the Generally Accepted Accounting Principles (GAAP). While GAAP isn’t a law, it is a set of guidelines for how to manage finances and share financial reports. Accrual-basis accounting is required under GAAP rules. If you aren’t sure whether GAAP applies to you, check with a certified public accountant (CPA) or accounting firm.
Here's how cash vs. accrual accounting looks in action.
Cash accounting method.
Cash accounting is the easier option of the two methods. It’s simple to follow, and maintaining records is fairly straightforward even if you don’t have years of experience managing company finances.
The cash method involves recording transactions when money is received or paid out. Acceptable forms of receipts and payments are cash, check, credit cards, and electronic transfers, in addition to several other payment methods.
Under the cash method, income is counted when payment is actually or constructively received. “Constructively received” means that funds are available to you without any restriction. For instance, your bank deposits an interest payment in your business bank account in November, but you don’t withdraw it until December. You’d report that revenue in November, when it was constructively received.
The cash method only works for some business models. If your company carries inventory or sells goods on credit, you’ll have to use the accrual method. Cash-basis entities only record transactions when money is exchanged. That means there’s no way to track future transactions like accounts payable and accounts receivable.
Advantages of the cash method.
If you’re eligible to use it, the cash method can offer a variety of benefits for your startup.
Simple to use.
The learning curve for the cash accounting method is much lower than for the accrual accounting method. You simply record transactions when cash is received or paid. There are fewer numbers to handle because you aren’t tracking accounts payable or receivable, or things like prepaid expenses.
Using the cash method, some startup founders are able to manage their books and accounts themselves rather than relying on a CPA. Expense-tracking and accounting software are usually all that are needed.
Clear cash flow.
Unlike the accrual method, the cash method deals with payments that exist in the present. That makes monitoring cash flow significantly easier.
Given that most businesses fail due to improper cash flow management, this method offers built-in protection. You aren’t considering future revenue or expenditures, so you always know how much cash your business has on hand.
More income tax control.
The cash method allows you to exercise some control over the timing of transactions, which can lower your tax costs.
For instance, let’s say your fiscal year ends in December 2020. Your business invoices a customer for $2,500 in December 2020 but doesn’t receive payment until January 2021. Under the cash method, that $2,500 would be part of your 2021 taxable income, reducing your 2020 tax liabilities.
Disadvantages of the cash method.
The cash method has a few significant drawbacks that could make it a bad choice for your startup.
Limited financial insight.
Because cash accounting creates a point-in-time snapshot of a company’s transactions, it offers limited predictive power. Business liabilities, like accounts receivable, aren’t included in the picture, so there’s a danger you’ll assume you have more cash to spend than you actually do. It may also be more difficult to anticipate revenue shortfalls.
Excludes some businesses.
If you maintain a product inventory or offer store credit to customers, you must use accrual accounting. This automatically rules out a large number of startups. In addition, if you exceed the $26 million gross-receipts threshold, you can’t use the cash method.
The cash method may make your business look like it has sporadic profits and losses or poor financial viability.
For example, imagine you purchase inventory for $10,000 in February. You don’t sell your products until March. When you close your books in February, there’s the $10,000 expense with no revenue to cover it, resulting in a loss. You sell the products in March for $15,000, so there’s a $15,000 profit. February shows a large loss and March shows an even larger gain, but in reality you had a revenue of $5,000 over two months.
Accrual accounting method.
While the cash method follows the money, the accrual method is based on matching. You’re essentially matching purchases and receipts to the time period when they occurred. It’s the more complex system of the two, and will likely require the help of an accountant or bookkeeper. But it also has its advantages.
Under the accrual method of accounting, companies record income when it’s earned, rather than when it’s received. And expenses are recorded when they’re incurred, rather than when they’re paid. For instance, your company fulfills a product order and ships the goods. Upon shipping, you would record this revenue.
Businesses that make over $26 million in sales revenue over a three-year period are required to use the accrual accounting method, as are public companies, according to GAAP rules. If your startup plans to share financial reports outside your company, these regulations may apply to you.
Advantages of the accrual method.
The accrual method is required for higher revenue startups, but favorable for businesses of all sizes.
Accurate and adaptable.
The accrual method gives you a more accurate picture of your company's true profitability and financial health. It’s built for high transaction volume, including accounts payable and accounts receivable, and involves fewer profit and loss variations since income and expenses are recorded when they happen.
While the cash method only allows you to report current transactions, the accrual method includes more accurate predictions of potential budget shortfalls and upcoming profits.
Beneficial for some tax purposes.
Similar to the cash method, the accrual method can give you some control over your taxable income.
For instance, imagine you order a new desk and laptop for your office for $2,500 in December 2020, the end of your fiscal year. Per your payment terms, you have 30 days to pay the bill. Under accrual accounting, you’d record the transaction in December 2020, even though you don’t pay it off until January 2021. That way, you get to deduct the $2,500 cost as a business expense on your 2020 tax return.
As you can see, the cash method and accrual method essentially offer opposite tax advantages. Both options give you the ability to shift income, liabilities, and deductions from one tax year to another depending on when you initiate a transaction. It all comes down to timing.
As we’ve mentioned, some businesses are required by GAAP to use the accrual method. But many startups eventually convert to accrual accounting anyway because investors ask for more complex performance reports or the founders’ plan to take the company public.
Transitioning from the cash method to the accrual method is an intensive task. You have to account for years’ worth of cash payments, accrued and prepaid expenses, and accounts receivable and payable. At the end of the day, it may be easier to just opt for accrual accounting from the start.
Disadvantages of the accrual method.
That said, the accrual method has a few key drawbacks you should consider before making your decision.
More complex system.
The accrual accounting method is significantly more complex than the cash method. Companies face the challenge of tracking unearned revenue and expenses, and there are more advanced accounts involved, like accounts payable and receivable.
In addition, the accrual method requires double-entry bookkeeping, so you’ll need robust accounting software — like QuickBooks or NetSuite — in order to keep track of your liabilities. Consider finding an accounting partner if you plan to use the accrual method.
Difficult to track cash flow.
Another downside to accrual accounting is the lack of visibility into cash flow. When it comes to cash flow, the accrual method offers an incomplete picture. Your account ledger or income statement may show thousands of dollars in sales revenue at any given time; however, you might not have that cash on hand for months. Companies can combat this inefficiency by preparing a monthly cash flow statement, which projects how much money will flow in and out of the business.
The bottom line: Cash vs. accrual accounting.
If your company is eligible, you may decide it’s easier to get started with cash-basis accounting. Alternatively, it may spare your team financial headaches later if you dive into accrual-basis accounting now, before scaling.