A start-up might wonder what the most effective and practical accounting method is for them. There are two main accounting methods; we’ll discuss the advantages and disadvantages in this article and explain how start-ups can choose the best accounting method for them.
Cash-Based Accounting
The simplest method of accounting for start-ups involves cash. It tracks all funds, including expenses and income, as they are paid or received. Start-ups don’t need to keep accounts payable and receivable, so most of them prefer this method. It also makes it easy to identify when transactions occurred.
Cash-Based Accounting Benefits
It’s Straightforward to Use
It’s much easier for entrepreneurs to master cash-based accounting since it’s the easiest accounting method. They may also save money this way.
Cash-Basis Accounting Requires Fewer Accounts and Less Information Than Accrual-Based Accounting
Business owners do not need to plan or get into specifics with cash accounting. That means they can focus more on the business and spend less time on accounting.
It Exists in the Moment
A cash-based accounting system accounts for funds received and spent in the present. Owners do not have to think about expenses or revenue in the future.
There’s a Potential Tax Benefit
Cash accounting can be beneficial to some businesses in terms of taxes. Earnings and expenses are recorded when money changes hands; this helps control timing.
Business Owners Can Control Transaction Timing to Slow Revenue Growth and Increase Expenses
They can legally increase their costs and decrease their income to reduce their tax burden.
The Drawbacks of Cash-Based Accounting
Despite its advantages, the cash-basis system has some disadvantages as well.
It Doesn’t Show the Whole Picture
One of the downsides of cash-basis accounting is that it shows business owners a limited view of their finances.
Business Owners Don’t Report Liabilities in Cash-Based Accounting
Consequently, they may think they have more cash to spend than they do. It does not show their customer’s liabilities to their company, which may lead them to overlook unpaid debts.
An owner may be unaware of the long-term health of their business since cash-based accounting only gives an overview of their finances. Decisions and growth may be affected.
Some Businesses Cannot Use It
Not every business can use cash-based accounting. Cash-based accounting cannot be used by companies that:
- Provide credit to customers.
- Exceed IRS guidelines for gross receipts
- Income needs to be accounted for through inventory.
Cash-basis accounting is also subject to IRS restrictions. The following types of businesses can’t use cash-based accounting:
- C corporations or partnerships whose average gross receipts for the past three years are more than $26 million.
The IRS explains that businesses that make, buy, and sell merchandise can’t use cash accounting. There is, however, an exception. A company can choose not to keep inventory if its average sales for the three preceding tax years were less than $25 million.
Switching Over May Be Challenging.
If your business grows, you may decide to change your accounting methods or may have to do so. Changing from cash to accrual requires some adjustments:
- Add prepaid and accrued expenses
- Add receivables
- Subtract cash receipts, cash payments, and customer prepayments.
You must also request a change in your accounting method with the IRS. To do so, file form 33115, Application for Change in Accounting Method.
Accrual Basis Accounting
Accrual accounting is slightly more complex. Money is tracked when the business earns it rather than when it receives it. Therefore, if a company lands a big customer and signs a contract, the start-up essentially makes this money throughout the contract, not when they receive payment.
This accounting method also recognizes when they owe creditors. It keeps track of all transactions in real-time, even when payment hasn’t been made. That means you can have a bill for something in your financial statements even if you haven’t paid it yet.
Business owners need to include accounts receivable and payable in their line items with accrual basis accounting. Receivables are the monies your business expects to receive in the future (items that have yet to be paid by the clients).
In contrast, accounts payables are future cash outflows or items that the business owes but has not paid.
This method works best because it provides a comprehensive and accurate picture of your business that matches the revenue and expenses in the period they occur. Investors find it particularly useful when making decisions about scaling.
When you’re unsure which method is best, start with cash-based accounting and move to an accrual basis as your business grows.
Accrual Accounting Advantages
Most businesses prefer accrual accounting over cash accounting due to its higher accuracy. Lenders or investors may require these metrics, and even if they aren’t, they will give the business a more stable appearance and increase its funding prospects.
In addition, accrual accounting makes businesses GAAP-compliant, a practice that will become more important in the future.
It is not uncommon for start-ups that begin with cash-basis accounting to eventually move to accrual-based accounting when applying for funding. Therefore, even if your business doesn’t follow the standard now, it will likely have to in the future.
Disadvantages of Accrual Accounting
Small businesses might lack the staff to manage this accounting system. Large companies have an entire department devoted to tracking and reporting transactions. A hospital might have an accounts receivable department to track patient billings and accounts payable department to track expenses.
Accounting on an accrual basis requires monthly reporting. Business managers are usually familiar with income statements and balance sheets as their monthly financial statements. Accounting reports are typically generated more frequently for accounts payable and receivable.
Although you can report income when a sale is incurred instead of waiting for cash on hand, it also means a business pays taxes on money it hasn’t received.
Which Accounting Method Is Best for a Start-up?
It depends on what type of start-up you are. You might decide it’s easier to use the cash accounting method now and switch to accrual accounting when you get more business. On other hand, you may decide it’s better to use it from the beginning so you can have a complete financial picture.
