Accrual Accounting: Building Financial Clarity for Strategic Growth

Accrual accounting is a revenue recognition practice where revenue is recorded as it is earned and expenses recorded as they’re incurred — regardless of when the money actually changes hands. Compared to other revenue recognition methods, accrual accounting provides a more accurate snapshot of a startup’s overall financial health, which can help facilitate better financial planning and analysis while also complying with GAAP and IFRS accounting standards.

As an experienced financial management and accounting firm that specializes in working with startups, Graphite Financial assists with implementing proper accrual accounting.

What Is Accrual Accounting and Why Does It Matter for Startups?

Accrual accounting records revenue and expenses as they occur, rather than when money is received. For startups, this helps match revenue and expenses in the same period and can help startups make better and more informed decisions by aligning any goals or objectives with recorded financial outcomes. Accrual accounting is also better for cash flow management and can help startups better plan and manage their cash flow.

Furthermore, accrual accounting helps appease investors and stakeholders, who rely on such data for decision-making purposes. Such statements tend to present a more consistent and reliable means of evaluating a startup’s performance and potential, two key factors that investors often weigh before committing. It also ensures compliance with accepted accounting principles GAAP, which are essential for startups looking to scale and attract funding.

How Accrual Accounting Works in Practice

Say your startup sells a product or service in November, but doesn’t actually receive the payment until January. If your startup practices accrual accounting, it will recognize the revenue in November when the sale is made — even if it hasn’t received the money for it yet.

Accrual accounting also uses double-entry accounting, which consists of utilizing two accounts when transactions are entered. One shows the income earned, but that hasn’t been received, while the other acknowledges the revenue earned during the period.

Some of the key concepts of accrual accounting that all startups should be aware of include accounts receivable, accounts payable and prepaid expenses.

Revenue Recognition Under Accrual Accounting

Based on operating models, startups will recognize revenue differently under accrual accounting principles. For instance, SaaS startups tend to recognize revenue over the period when the service is delivered, regardless of whether the service is paid for upfront. eComm startups, conversely, tend to recognize the revenue at the time of a transaction.

There are also ASC 606 regulations that startups need to comply with. This is a detailed process that consists of reviewing contracts, identifying performance obligations, determining a transaction price, allocating the price relevant to the performance obligations and then recognizing the revenue when all the obligations are successfully fulfilled.

Good accounting practices can also help startups avoid some of the common challenges, such as misclassifying expenses, overlooking depreciation, failing to record expenses/income and more. Following these practices helps ensure accurate financial statements that reflect the true financial position of the business.

Expense Recognition Under Accrual Accounting

To record expenses under accrual accounting, startups should debit the expense account and credit the accrued liability account — and then reverse the entry when the payment is officially made. Some of the most common expenses that startups need to manage include salaries, contractor payments and commissions.

Expenses must also follow the matching principle, meaning expenses must be recognized in the same period as the revenue they help to generate.

Accrual Accounting vs. Cash Accounting: Making the Right Choice

When should startups transfer from cash to accrual accounting? Generally, this switch should be made when startups begin to scale and when they seek to attract new investors to fuel their business. Cash-based accounting tends to be easy to implement, while accrual accounting requires more advanced software and bookkeeping expertise. However, the payoff of implementing accrual accounting is the overall snapshot of your company’s financial health that it helps facilitate. It’s also a more attractive accounting method to investors.

This isn’t just a recommendation, it’s a requirement. Accrual accounting is actually required of startups that earn at least $25 million in revenue over three years. Noting this, if your startup scales and grows, it’s going to have to switch from cash to accrual accounting to comply with standards and regulations.

The Benefits of Accrual Accounting for Startup Financial Management

Some of the key benefits of accrual accounting for startups include:

• The method provides a more accurate overall picture of your startup.
• It can empower startup leadership to make better, more informed decisions based on financial data.
• It helps with fundraising efforts by providing the data that matters to investors.
• It supports accurate financial reporting, which is essential for compliance and investor confidence.
• It can help support better overall financial forecasting and strategic planning.

Common Accrual Accounting Challenges for Startups

While accrual accounting has its benefits, it’s also a more challenging system to implement that requires advanced bookkeeping expertise. That said, some of the common pain points of accrual accounting for startups include:

• Resource requirements and technical experience.
• Lack of detailed record keeping.
• Revenue recognition challenges.
• Potential cash flow issues.

These challenges underscore the need to ensure the right person or team of professionals is managing your finances. Often, it can be too expensive and strain resources to hire someone to do this in-house. Contracting with an external partner is one alternative.

Setting Up Your Accrual Accounting System: Essential Tools and Processes

Accrual accounting is more complicated than cash-based accounting, and it requires a more robust system to operate effectively. Look for features such as automated calculations, entry generation, audit trails and integrations with other systems.

It’s also important to arrange a chart of accounts to properly organize and keep track of financial transactions and accrual-based financial data.

How Graphite Helps Startups Master Accrual Accounting

Accrual accounting requires a certain degree of expertise and experience to master, and it can make sense for startups to partner with an experienced accounting firm to implement and maintain such systems. That’s where Graphite can help. With a wealth of experience handling complex accrual accounting issues and a specialty in helping startups grow and flourish, Graphite professionals are well-suited to handle your bookkeeping.

Get Started with GAAP-Compliant Accrual Accounting Today

For more information on accrual-based accounting and insight on implementation and bookkeeping, contact Graphite today. We specialize in working with startups and can help ensure your startup is in a good position to attract investors, meet compliance requirements and grow. Our team ensures alignment with generally accepted accounting principles to give you clarity and confidence in your financial reporting. Contact us today for more information and to schedule a free consultation.

FAQs

What is the difference between accrual accounting and cash accounting?

Accrual accounting is a revenue recognition practice where revenue is recorded as it is earned and expenses recorded as they’re incurred, regardless of when the money actually changes hands. Cash-based accounting records revenue when money is either spent or received.

Does GAAP require accrual accounting for all businesses?

No, but GAAP standards do require accrual accounting for startups that earn at least $25 million in revenue over three years. If you’re under this threshold, cash-based accounting is still OK for you from a regulatory standpoint.

When should a startup switch from cash to accrual accounting?

Generally, this switch should be made when startups begin to scale and when they seek to attract new investors to fuel their business. If your startup continues to grow, it will have to switch if it earns at least $25 million over three years, per GAAP standards.

How does accrual accounting impact tax reporting for startups?

Because income and expenses are recorded when earned, they may be shifted between tax years. This can have an impact on your startup’s total tax liability and cash flow.

What are the most common accrual accounting mistakes startups make?

Some of the most common accrual accounting mistakes startups make include inaccurate cash flow tracking and improper record-keeping and categorization.

How does accrual accounting affect financial metrics that investors look at?

Accrual accounting provides a more accurate snapshot of a startup’s overall financial health, which can help investors more accurately assess a startup’s financial health and gauge its potential.

Can a business use both accrual and cash accounting methods?

Hybrid methods combine elements of both practices, which can be advantageous for startups with complex financial situations.

What are the key journal entries unique to accrual accounting?

Key entries include accrued expenses, accrued revenues, deferred expenses and deferred revenues.