Deciding Between Accrual and Cash AccountingChris Schwalbach · October 24, 2016 · 5.6 min
Over the past few months, we have been asked by numerous business owners, “I’ve been told by others that I should switch to accrual accounting, but it seems harder, and what are the pros and cons?” We heard the question several times, but our answers varied depending on the company. We could not find a comprehensive business owner’s guide for this topic on the Interwebs so we created our own.
First off, this guide is not about the technical differences about Cash vs Accrual Accounting and this is not an accounting system implementation guide either. This is simply a “what method should I choose for my business” or “should I switch to accrual accounting for my business” guide.
Also, for the purposes of this guide, we’ll be using the term Accrual method, which we are using synonymously with the term GAAP (Generally Accepted Accounting Principles) or IFRS (International Financial Reporting Standards) for those less familiar with accounting.
Second, to set this up, it’s important to point out that you may maintain your “internal books” under one method of accounting and file your “tax books” under another method of accounting. For example, your books may be maintained under Accrual method, but your taxes filed using Cash method. This is very straightforward for tax professionals to make “adjustments” to Accrual based books to file taxes under Cash method. With that said the corollary is not true…it’s very challenging to take Cash method internal books and convert them to Accrual method for tax purposes. More on that below…
Our decision guide is really a simple hierarchical decision tree. If you answer “yes” to any of the questions, then you should probably use Accrual accounting method for your business.
#1 – IRS Rules: Is your business required to use accrual accounting under IRS regulations?
The IRS requires that business owners use accrual accounting method generally if the business has a) over $10 million in gross receipts (sales) and b) is an inventory based business. The IRS rules are lengthy, but your tax provider should easily be able to determine whether you are required to file taxes under the Accrual method. As mentioned above, if you are required to file taxes under Accrual method, then it’s best to maintain your internal books using the Accrual method.
#2 – Compliance or Expected Compliance Requirements: Do you have or expect to have investors, creditors, regulators, or other parties whose involvement with your business will require Accrual (GAAP or IFRS) method accounting?
Your business may be currently bootstrapping its growth, but in your plans, you expect to get a loan from a bank or bring in investment capital. If you believe that your business will have “outside eyes” analyzing and reviewing the performance of your business, then we recommend adopting Accrual accounting. To be clear, this is not a hard and fast rule, however the larger the investment/loan, the greater the likelihood that there’s an expectation that books are maintained (and financial models/projections are built) on an Accrual method.
For example, we’ve worked with companies who are getting a $250,000 working capital line from a commercial bank and cash based financials tend to be “acceptable” with a good history of operations. However, trying to negotiate a $4M term loan with a bank based on cash based books, is a little harder – both because the analysis of your business is more challenging, but also because the bank is observing that you’re managing the business on a less sophisticated “cash basis”. As another data point, venture capital term sheets typically stipulate GAAP accounting and annual financial audits after their investment.
Why? While not the purpose of this guide, the two core reasons are 1) GAAP or IFRS ensures an “accounting standard” by which the investor / creditor can rely on (because you are signing a warranty in the investment documents that your financials are compliant to standards) to review your financials, and 2) the analysis of accrual accounting financials provides a more comprehensive view of the trends, trajectory, profitability, and cash flow of the business.
#3 – Future Goals
The goals for your business are an important consideration in selecting accounting method. If your goals are to develop a lifestyle business that you plan to own and run for a long time, then Cash method may be suitable for your needs based on its simplicity and ease. However, if you plan to sell your business in a meaningful exit, then, similar to #2 above, buyers will have a higher expectation for third party audited accrual (GAAP) financials.
If your exit is nowhere in sight at this point, then cash basis may be just fine. However, I would plan to have 3 years of Accrual based financials prior to an exit. So, if you can see the possibility of an “exit” in the next 2 years, it might be a good idea to go back and convert the last year’s financials from cash to accrual and then maintain Accrual accounting going forward.
#4 – Internal Analysis
Even if you have no compliance to near term business exit plans, using Accrual method accounting might be best if the complexity of your business is significant. As your business grows, the ability to analyze the profitability of your company’s performance gets increasingly more challenging if you maintain your books on a cash basis. For example, subscription based businesses may receive up-front cash, but have future obligations to provide for that subscription. Cash accounting would show all the revenue (from cash paid) but would not account for the expenses that are required over the next 12 months. Accrual accounting matches the earnings with the expenses of providing that subscription. It’s hard to know if you’re ahead or behind “plan” if you’re on a cash basis. As another example, timing differences between paying for inventory and receiving cash from customers multiply as your business grows and the profitability analysis becomes significantly more challenging if managing on a cash basis. The cash basis can look super lumpy and it’s hard to see any warning signs through the financials, making it more challenging to understand the true performance of the business.
With that said, accrual accounting comes at a cost. It is more time intensive to manage, and usually requires a person with an accounting background to assist with the month-end journal entries. This extra time and cost will produce more professionally a more professionally managed set of financials that can provide great insights into your business. Thinking through the goals of your company should be the main driver behind what type of books you should keep.
Chris Schwalbach, 2016