One of the first major accounting decisions every entrepreneur must make is which accounting method to use. The most commonly used methods are cash and accrual1. The overarching difference between the two methods is the timing of income and expense recognition. On a small scale, the choice of accounting method may seem insignificant, but as a startup grows in scale and transaction complexity, cash and accrual financial reports may present a very different financial outlook and contribute to very different business decisions.
Sometimes companies choose to change from one accounting method to another, usually from the cash method to the accrual method. This article will give a brief introduction of the two accounting methods, followed by an overview of how and when to switch from cash to accrual. Note that the IRS’s accrual standard differs slightly from Generally Accepted Accounting Principles (GAAP). For this article, accrual accounting will refer to GAAP accounting unless otherwise specified.
The cash method focuses on the timing of cash flows rather than the timing of transactions. A sale or expense is not recognized until cash is received or remitted. This simple concept yields the following advantages:
- Easy to implement
- Clear understanding of actual cash flows
- More opportunities to defer income or accelerate deductions (e.g., delay receiving sales proceeds until next period)
- Enough cash to pay taxes (i.e., income is not subject to tax until cash is received)
In many instances, startups adopt the cash method simply because the owners do not have adequate accounting expertise and so accounting is something of an afterthought. Consequently, many of these startups fail to hire qualified personnel to handle accounting operations, and the cash method becomes the quick and easy solution, despite the following disadvantages:
- Limited insight of company operation (e.g., recognition does not reflect upcoming or past-due payments)
- Difficult to produce financial statements that satisfy institutional investors, lenders, and auditors
- Potential mandatory change of method for certain business activities or regulation requirements (see section below titled “When to Switch from Cash to Accrual Accounting?”)
The accrual method emphasizes the timing of actual transactions. Revenues and expenses are recognized when transactions are performed, not when cash is received. To indicate the timing difference between transactions and cash flows, accrual accounting utilizes accrual accounts such as “accounts receivable,” “prepaid rent,” and “wages payable.”
The advantages of the accrual method include the following:
- Better understanding of financial position and performance (matching income and expenses to their exact period)
- Acceptable to the SEC, and commonly requested by institutional investors, lenders, and auditors
The disadvantages of accrual method include the following:
- Time-consuming to implement and maintain
- Higher cost due to required time commitment and professional skills
Ultimately, startup owners/managers should weigh the pros and cons of each method and find the method that provides the most relevant financial information for business decisions.
When to Switch from Cash to Accrual Accounting?
The benefits of cash accounting are often appealing to startups, and many startups continue using the cash method until they face situations that would make accrual accounting a more appropriate method. Below are some of the situations or events that might trigger a switch from cash to accrual accounting.
For tax purposes, the IRS implements the “gross receipt test” to evaluate if a company is permitted to use the cash method (the accrual method is always permissible). For example, a corporation or partnership with an average annual gross receipt2 of 5 million or less is permitted to use the cash method. There are many other exceptions to the gross receipt test based on entity type, special qualification, and the nature of a business. Please see IRS Publication 538 for regulation details. The bottom line is that most companies will have to switch from cash to accrual accounting once the business grows to a certain scale to comply with the tax code. In practice, many companies keep two sets of financial records using different accounting methods, such as an accrual method record for tax and a cash method record for business operations.
The SEC regulates the financial reporting of publicly-traded companies. The SEC has mandated that all companies pursuing an Initial Public Offering (IPO) comply with US GAAP (an accrual method of accounting), be audited by a Certified Public Accountant (CPA) registered with the Public Company Accounting Oversight Board (PCAOB), and be approved by the SEC before they can be listed on an exchange market. The IPO process can be lengthy and complex, and missing the “IPO window” can be detrimental to company funding and future performance (see “Timing Your IPO – Market Windows”); thus, many companies choose to hire professional service firms to assist with the IPO process, including converting from cash to accrual accounting if the firm has not already made the switch.
Audited financial statements can be helpful even before an IPO, as many institutional investors and creditors often request them before considering and approving funding. Since GAAP standards (for public companies) and AICPA standards (for private companies) both call for the accrual method, startups will need to convert from cash to accrual accounting in preparation for a formal audit.
How to Switch from Cash to Accrual Accounting?
Since the basic concept of accrual accounting is to match income and expenses to the period in which they occur, converting from cash to accrual accounting essentially means adjusting the discrepancies between the timing of cash payments/receipts and the actual exchange of goods or services. Below are three scenarios in which we demonstrate the conversion from cash to accrual accounting and the associated impact on net income.
Scenario One: Delay of Cash Collection from a Customer
Assume X Corp made a sale of $100 and delivered the product in Year 1, but the customer did not pay the $100 until Year 2. Using the cash method, X Corp would not recognize the revenue of $100 until Year 2, and net income is unaffected in Year 1. To convert X Corp from cash to accrual accounting, X Corp will shift the recognition of $100 revenue from Year 2 to Year 1 and create an accounts receivable with a balance of $100 for Year 1. For the $100 cash received in Year 2, instead of classifying it as revenue, X Corp simply treats it as a reduction to accounts receivable. One can see how the accrual method recognizes revenue at the sale transaction despite the timing of cash collection.
Scenario Two: Payment in Cash for Inventory Purchased Without Selling the Inventory in the Same Year
Assume that X Corp purchased inventory worth $200 in Year 1 and paid the supplier in full. Using the cash method, X Corp would recognize $200 of expense (cost of goods) in Year 1, and Year 1’s net income would consequently be decreased by the same amount. In Year 2, X Corp sold the inventory for $300 and therefore recognized a revenue of $300 but no cost of goods sold (already recognized in Year 1). Consequently, net income of Year 2 increased by $300. To convert the accounting for this transaction to the accrual method X Corp would derecognize the $200 cash paid for inventory and instead recognize it as an asset, thus net income in Year 1 would remain unaffected by this transaction. In Year 2, X Corp would not only recognize the sale of inventory with $300 revenue but also $200 for cost of goods sold. The net effect is an increase of $100 in Year 2’s net income. Through this example one can see that the cash method has the potential to cause bigger fluctuation in year-to-year net income than the accrual method, especially if the business commonly experiences lags between the purchase and sale of goods.
Scenario Three: Payment in Cash in Advance for Rent
Assume X Corp leases an office space. The rent is negotiated at $500 per year. At the beginning of Year 1, X Corp made a cash payment of $1000 to the landlord, specifying that $500 is for Year 1’s rent and the other $500 is an advance payment for Year 2’s rent. Using the cash method X Corp would recognize rent expense for $1000 in Year 1, and net income for Year 1 is therefore lowered by $1000 but Year 2’s net income is unaffected by this transaction. To convert the accounting for this transaction to the accrual method X Corp would only recognize $500 of rent expense in Year 1 and set up an asset account titled “prepaid rent” with a debit of $500. At the end of year 2, X Corp would credit the prepaid rent account for $500 to empty the account with an offsetting $500 debited to rent expense. The net effect is that X Corp would recognize $500 of rent expense in both Year 1 and Year 2. One can see how the accrual method matches income and expenses with actual economic creation and consumption of values.
The above examples demonstrate that cash-to-accrual conversion will have a direct impact on the firm’s earnings due to the timing of income and expense recognition. Also, new asset accounts with words like “prepaid” or “receivables” and new liability accounts with words like “payable” or “accrual” will also appear.
The cost, expertise, and time required for accounting method conversion can be enormous. In fact, an Accounting Tools article states that “the only way to be certain of a complete and accurate conversion is to examine all accounting transactions during the year being converted, as well as…in the preceding year. Thus, the conversion is both labor intensive and expensive.” The moral of the story is that startups should not delay switching from cash to accrual accounting once a major growth event such as an IPO becomes a possibility. In fact, if a firm has qualified accounting personnel, it may be prudent to adapt the accrual method to begin with.
Most accounting software, such as QuickBooks, supports both cash and accrual methods of accounting, and even allows users to create cash and accrual financial statements at the same time. However, management should still research different accounting software providers to ensure the software supports the method management desires to employ.
If your firm decides to use cash accounting from the onset, make sure to keep detailed records for all transactions, as it is often the only way to ensure an accurate and complete conversion process when you decide to switch to the accrual method.
Cash and accrual accounting methods are both common in practice; thus, startups should understand their advantages and disadvantages, and choose the method best suited to their company based on both short- and long-term business objectives and strategies. Firms that need to convert from cash to accrual accounting should act early and allow sufficient time for qualified experts to make a smooth and comprehensive transition.
- InDenero: Making the Switching from Cash or Accrual to GAAP Accounting
- Accounting Tools: How to Convert Cash Basis to Accrual Basis Accounting