How to implement the accrual accounting method in your startup

Let's be honest: Getting a grip on your startup's finances can be a real headache when you don't have a solid accounting system in place. You may be dealing with delayed payments, unrecorded revenues, and a whole lot of guesswork.

Or, maybe you use the cash accounting method, but you've outgrown it. Now, simply recording your transactions and payments when they're processed may mean a less accurate picture of your startup's finances. Sticking with this method for too long can obscure your financial health, choke your cash flow, and blur your financial foresight.

When it's time to choose a different type of accounting method, a good contender is accrual accounting. With the accrual accounting method, you record your earnings and expenses as they happen, cash or no cash. By recording transactions as they occur, you can use accrual accounting to get a real-time snapshot of your financial health, not just a history lesson. This shift can be the difference between navigating in the dark and having a clear roadmap for your financial decisions.

As we dive into accrual accounting, think of it as upgrading your financial toolkit. It involves adopting a proactive stance about your revenue and expenses so you know where your business's finances stand. Read on to learn how accrual accounting can help set you up for a smarter, more strategic financial journey.

What is accrual accounting?

Accrual basis accounting is like GPS for your startup's financial journey. You don't just look at when money physically enters or exits your bank account. Instead, you also track every financial move as it happens. Whether it’s your revenue or expenses, accrual accounting records it all in real time, giving you a complete, up-to-the-minute view of your financial position.

The accrual accounting method also helps you accurately report your financial performance. This method follows the Generally Accepted Accounting Principles (GAAP), which is a set of standard guidelines for companies to follow when preparing financial statements. GAAP ensures consistency and comparability in financial reporting, making it easier for investors and stakeholders to understand and compare different businesses.

Differences between accrual and cash accounting

The main difference between cash vs accrual method of accounting has to do with when you record expenses and sales. With cash basis accounting, you wait for the actual exchange of cash to happen before you write anything down in your books. It’s straightforward, so small business owners often use it when they only deal with simple transactions. While cash accounting might be easier to get your head around and manage, it’s not without its pitfalls. It can sometimes give you a skewed view of your long-term profitability and financial health.

Then there’s accrual accounting, which takes a more comprehensive approach. It uses the matching principle to record transactions when they occur, regardless of whether or not you've exchanged cash payments. While this method may be a bit more involved, it gives you a truer picture of where your company stands financially. This is especially true if your business has inventory to manage, offers credit to customers, or has significant expenses paid in advance or deferred to later.

Imagine your startup offers a cloud-based project management platform, and a new client has just signed up for a $1,000 subscription. In cash accounting, you record this amount when you receive the money. But in accrual accounting, you record revenue the moment you sell the subscription, not when the cash finally lands in your account. Similarly, if your startup pays server hosting fees, you log them as soon as you incur them, not when you write the check.

Key components of accrual accounting

Two fundamental components define accrual accounting: revenue recognition and expense recognition. Let’s break them down.

Revenue recognition

In accrual accounting, you recognize revenue when you earn it, not necessarily when you receive cash. This means that even if you have not yet received payment for a sale or service, you still record the transaction as revenue in your books.

Consider this scenario: Your business finishes a job in January, but the cash doesn’t hit your account until February. In the world of accrual accounting, you don’t wait for the payment to come through to say you’ve earned that money. You record the accrued revenue in the same month you did the work. This method lines up your income with the expenses you racked up to earn it, showing a true reflection of your profitability in that period.

Strict accounting standards and principles guide revenue recognition. These encourage precise reporting times for income and prevent manipulation of financial statements. This approach is particularly important if your business deals with long-term contracts or subscription-based models for which you might realize revenue over an extended period of time.

Expense recognition

Just like revenue, you record expenses in accrual accounting when they occur, regardless of whether you've paid them yet. This method links expenses directly to the revenue they help to generate, offering an accurate representation of your company's profits and losses.

For instance, if a business incurs an expense in February but pays the bill in March, it recognizes the expense in February.

Accurate expense recognition is vital for effective financial management and planning. It helps you keep track of your financial obligations and assess the true cost of operations within a specific accounting period. This provides valuable insights so you can reduce or optimize expenses for improved profitability.

Steps to implement accrual accounting

Shifting to accrual accounting in a startup is a multi-step journey, each one critical for accurate and compliant financial reporting. From assessing your business needs to setting up the necessary processes, the following sections outline the key steps you need to take.

Assess your business' suitability for accrual accounting

The journey begins with a critical look at your startup's unique needs. If you're eyeing rapid growth or juggling complex transactions, accrual accounting could be the right choice for you. Here are a few additional considerations to focus on:

• Adjusting opening balance: Making the move to accrual accounting often means revisiting your opening balance sheet. Here, you should recognize any receivables, payables, and prepayments that you haven't recorded yet. Getting this right will make sure your financial statements are in line with accrual accounting standards.
• Handling prepaid expenses and deferred revenue: In accrual accounting, you record prepaid expenses, or costs paid in advance, as current assets. Additionally, you count deferred revenue  — income received but not yet earned — as current liabilities. This setup matches your business transactions with the time periods they belong to, offering accurate accounting that provides real-time financial insights.

Transition from cash to accrual

Shifting from the cash method to accrual accounting might seem daunting, but a well-charted plan can make things easier. Here are some tips to ease the transition:

• Grasp the impact: Get a handle on how switching to accrual accounting will shake up your financial statements. Expect to see a bump in your income due to receivables and a possible uptick in expenses from those you’ve incurred but not yet paid.
• Timing matters: Brush up on when to recognize revenue and expenses. That way, you can get used to recording these things when you earn and incur them versus when you receive or pay for them.
• Chat with an accountant: It’s always a good idea to consult an expert. An accountant can help you navigate the transition. They can also make sure that your financial statements are accurate and in line with accounting standards.

Setting up accrual accounts

Setting up accrual accounts involves creating and managing ledgers for accounts receivable and accounts payable. This step is crucial for tracking the money owed to you and the money you owe. Be sure to:

• Get your software ready: Double check if your accounting system can handle accrual-based transactions. You'll need to set up separate journal entry accounts for receivables, payables, and those accrued expenses you’ve paid for in advance.
• Stay on top of reconciliations: Accrual accounting demands diligent record-keeping and frequent reconciliations. Regularly compare your accounting records with bank statements and other financial documents.

Implement accrual policies

To maintain consistency and compliance with accrual accounting standards, it's important to implement clear guidelines for recording transactions. Consider the following recommendations:

• Policies for revenue recognition: Define the criteria for recognizing revenue. For instance, if you're running a service-based startup, you should decide when to recognize the revenue from a project. This could be upon signing the contract, reaching milestones, or completing the project.
• Expense recognition policies: Establish guidelines for recognizing expenses. This includes deciding how to record and allocate costs like salaries, rent, and utility bills over time.
• Timely recording of transactions: Make sure your team records all financial transactions promptly and accurately. This includes any adjustments, such as reversing previous entries or adjusting accrual balances.

Train your team

To successfully implement accrual accounting, educate your team about the new system. This includes training them on how to properly record transactions and adhere to the established policies. Some key areas to focus on include:

• Training for specific roles: Identify roles in your organization that are directly involved in financial transactions and provide them with specialized training on accrual accounting processes.
• Educational workshops: Conduct workshops to familiarize your team with the basics of accrual accounting. This is particularly important for staff members handling billing, accounts payable, and accounts receivable.
• Ongoing support: Offer ongoing support and resources. Consider periodic refresher courses and provide access to accounting manuals or online resources.
• Collaboration with departments: Encourage collaboration between departments — like sales, procurement, and finance — to improve the accuracy and timeliness of financial reporting. Cross-departmental knowledge can help your team better understand how their roles impact your startup's financial health.

Make accrual accounting work for your startup with the right tools

Transitioning to an accrual-based method of accounting is a major step for your startup. It's a sign that your business is growing and that you're ready for more advanced financial management. Whether you're searching for investors or making strategic business decisions, accrual accounting will provide a more accurate picture of your business's financial health.

Remember, you're not alone in this journey. Consider consulting with financial experts who can guide you through the process. When combined with the right tools, such as automated accounting software and robust bookkeeping services, expert guidance can help streamline the transition without overwhelming your team. Get started today and make accrual accounting work for you!