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What is Accrual Basis Accounting?

One small example to understand one major difference.

Using Accrual Basis Accounting will put you ahead of other startups

When is the right moment to acknowledge an income or expense? Is it when the bank movement takes place? Or should you reflect it on your P&L when the asset or passive is originated? 

These two accounting methods bring different results, and the question of which one should you choose for your startup is more important than you think. 

Let’s get this straight away: if you are at a very early stage and you haven’t begun to think about fundraising, the Cash Basis accounting method is good enough.

It’s easier to manage, less time consuming and it’s still precise to a certain extent. In B2C, where transactions occur almost immediately, it is not uncommon to see this method being used even at a later stage of growth.

However, if you are a SaaS or B2B company and aiming BIG, you should learn the difference and begin using the Accrual Accounting Method sooner rather than later.

Unlike the Cash Basis, the Accrual method records “accounts receivable” and “accounts payable”. It recognizes transactions when they are earned or assumed by your company.

All publicly traded companies use the accrual method, since it brings a more accurate description of the company’s health and stability.

Finally, you should be aware that the IRS will ask you to keep the chosen accounting method for a complete tax year, once you’ve decided which one to use.Small examples to show a big difference:

Imagine you provide a specific software service for 12,000 dollars and the project has a duration of 1 month but you agree that it will be paid in 12 installments once the task is finished.

 
-Recognizing income with Cash Basis Accounting

Using this method, the sale will only be reflected at the moment when those 12 installments are paid and not in the month when the contract was signed with the client and the service was actually provided.
But in this case, using the Cash Basis Method is decreasing your company’s value in the eyes of an investor, since it fails to recognize at the beginning of the process that there’s a stable flow of cash coming in for the next 11 months.

 
-Using Accounts Receivable

If you are using the accrual method, an investor will take a look at your balance sheet and see that your sales for the first month were actually $12.000. $1.000 are already in your bank account, and $11.000 are accounts receivable.

 

-Recognizing expenses with Cash Basis Accounting

If for the project in the example you have to invest capital for one month of salaries (say $4,000) that are paid following the month they worked, the company will appear to have incurred no expenses in the first month when in fact these resources have already been consumed.

But in fact, an investor will not see this with happy eyes, since they can’t predict your cash flow in the immediate future. This is a Red Flag in your Due Diligence.

 

-Synch your income and expenses

Using the Cash Basis method you will notice that our income and expenses are not synchronized.

Your books will show a profit spread over 12 months (due to the 12 installment financing) and therefore several of those months will not have any expenses to justify that profit because they have already been paid in the month following the contract.

With the accrual method you would record a profit in the month of the contract and the month of service provision, and the expense in salaries that same month regardless of when the money was paid or received. As a result of this method, the corresponding A/R or A/P will result. And finally your financial statements will more accurately reflect your reality

By using the Accrual method, every month you will recognize a weighted increase of your salary accounts payable that will disappear when you pay. But as you have acknowledged them before, the monthly salary expenses will be smooth and manageable. The due diligence will shine green lights on you, without a doubt.

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