Why startups need accrual accounting
TL;DR (quick answer)
1. Your investors will want you to use accrual basis.
2. Budgeting and forecasting are easier with accrual basis.
All companies have to choose between accrual basis accounting and cash basis accounting.
The Cash Basis Accounting Method
Revenue is recognized when received, and expenses are recognized when paid. Money in, money out.
This means that means your accounts payable and accounts receivable do not appear on your balance sheet until the cash changes hands.
Why your investors will have an issue with the cash method.
Let's say you run a SaaS business and this month you ran a successful ad campaign resulting in a large number of subscriptions sold.
Your end of month balance sheet shows all that cash coming in, but because the invoice for your ad spend isn't due until next month, your expense to acquire those customers does not show up on this month's balance sheet.
So your investor can't see how much you are spending to earn new customers.
It's difficult to invest in a company when you can't see the economics of your business model.
Even without investors looking at your books, with cash basis accounting, once you have any level of complexity in your business model, you won't have a clear picture of how your revenue is affected positively or negatively by your expenses.
When is cash basis accounting a good fit?
If you don't plan to raise institutional money (angel, seed, series A,) and if you have a simple business model where you don't need to worry about job costing or attributing expenses to monthly recurring revenue (MRR) you could be okay with cash basis accounting.
Many small business owners will opt to use cash basis accounting because with a simple business model their bookkeeping/accounting concerns are more about cash on hand and tax implications than they are about company valuations and forecasting the costs of scaling.
The Accrual Basis Accounting Method
Revenue is recognized when the sale is made, and expenses are recognized when they occur, regardless of when money changed hands.
Here’s an example... You run an ad campaign this month. You won't be invoiced until the end of the month, and you won't pay the invoice until next month.
Using cash basis accounting, you would have recognized the expense next month when you pay your bill. With accrual basis accounting, you will recognize the expense this month, the month in which you ran the ads, and received the benefit of the expense.
Why investors want you to use accrual basis accounting.
Accrual accounting matches income to the time of the transaction, regardless of when you get paid, and matches expenses to when you receive what you purchased, regardless of when you paid for it.
This method gives your investors much better insight into the metrics that drive your business and provide context for your forecasting and budget planning.
When you should begin using accrual accounting.
If you've raised money, your investors have probably already told you to make the switch.
If you are building a company where you plan to raise funds and scale at a rapid pace, then now is the time.
If you have been bootstrapping through the early phases of your startup but have plans to raise money in the future, you will likely want to start with accrual accounting at least a few months before approaching investors. You want to provide enough time to clean up your old books, establish proper accounting policies, and have the necessary information available for your 409A valuation and pro forma.