Why Change From Cash to Accrual Accounting?
Why change from cash to accrual accounting?
Although every business is unique, the one need everyone has in common is good accounting management practices. Regardless of what industry your business operates in – be it in tech, distribution, logistics, or services – understanding your current financial picture is critical to long-term success.
While most businesses start with cash basis accounting, managing the books can get more complicated over time. Adding employees, managing payroll, and keeping on top of accounts payable can muddy your overall profit and loss picture, making it difficult to make future growth plans.
If you are spending more time per month balancing the books, it may be time to change from cash to accrual accounting. While it will take some work to make the move, the rewards will allow you to spend less time working on money management, and more time on driving your business forward.
Accrual basis accounting allows for business owners to recognize revenue and match the associated expenses in that same period. This allows for better tracking of margins and overall financial statement analysis, as the delay in cash receipts or payments is removed from the analysis.
The difference between cash basis and accrual accounting
As with many things in life, the key difference between cash accounting to accrual accounting is in timing. While cash basis accounting allows business owners to get started, accrual accounting allows owners to understand the bigger picture and make plans around their trajectory.
With cash basis accounting, a business owner will record earnings and expenses as they happen. For example: If a small business does $550 in sales and signs a contract worth $1,200 on Monday, $350 in sales on Tuesday, and pays a bill for $125 on Wednesday, those transactions would all be recorded in real time as they are collected. The contract from Monday would not be counted until it is paid for.
Under accrual accounting, the business will record the transactions as they are received, not as they are paid. Using the same example from above: The only new item to go into the ledger is the Monday contract, as all other transactions would have already been logged and accounted for as a receivable.
Why accrual accounting needs double-entry bookkeeping
To provide an accurate picture of a business’s accounts, accrual accounting relies on double-entry bookkeeping to ensure balance. By entering each item twice – once when the contract or bill is received, and once when it is resolved – companies can reduce the chances of errors and get a larger picture of all their assets, liabilities, equity, revenue, and expenses. Moreover, double-entry bookkeeping allows partners and potential investors to see the average time it takes for cash flow to be resolved, indicating the overall health of a company.
Limitations of cash accounting in SaaS
When your Software-as-a-Service (SaaS) company begins seeking investors – either through seed funding or a Series A offering – making the change from cash to accrual accounting will be critical for your potential opportunities. While cash accounting is easier for startups, it is very limited in showcasing key performance indicators, such as monthly recurring revenue (MRR), revenue by month, or cashflow balance.
Because the SaaS business model is dependent on both monthly recurring revenue (MRR) and annual recurring revenue (ARR), potential investors and partners will demand to see a full picture of your business income. Transitioning to accrual accounting allows future partners to fully understand overall cash flow, the average revenue per customer, and can be audited when doing due diligence research. Finally, double-entry accrual accounting is considered compliant with generally acceptable accounting principles (GAAP), which is required for audit purposes. In order to ensure long-term success, accrual accounting should be part of your overall plans.
When should you consider switching?
Making the change from cash to accrual accounting isn’t for every business. Small businesses and startups don’t necessarily need to make the move until they have reached certain financial milestones, including meeting earning thresholds or preparing to go public.
Under IRS regulations, corporations or partnerships earning more than $5 million annually must report their finances using accrual accounting. In order to make the switch, your team of accountants will need to file IRS Form 3115, and include your business profit and loss statements alongside the previous year’s balance sheet. The form can be filed at any time after the beginning of your tax year.
Companies who are planning fundraising rounds to the public must abide by the rules of the U.S. Security and Exchange Commission (SEC). One of those rules is to abide by GAAP requirements as issued by the Financial Accounting Standards Board (FASB). Not only does accrual accounting abide by GAAP, but it also gives additional transparency to potential investors, allowing your company to make a strong case for your growth potential.
Audits are a regular part of the business process, and are often completed when requesting lender credit or prior to annual investor meetings. Shifting to accrual accounting makes the auditing process easier because much of the work is already completed: your accounting team simply needs to verify that all double-entries are valid, and make corrections on out-of-place or unreconciled entries.
Step-by-step instructions on converting from cash to accrual accounting
While it may sound daunting, converting from cash to accrual accounting is a straightforward process that can help your company grow well into the future. Whether you decide to hire an accounting team for your startup or make the move in-house, these steps can help you get the process started.
Add accrued expenses
The first step is to start adding accrued expenses as they come in. An accrued expense is anything your company is obligated to pay, but has not yet submitted. For instance: When your company receives a bill from the power company and will pay it at a future time, it is considered an accrued expense.
Subtract cash payments
Once payments are made to accrued expenses, they can be subtracted from the cash. This represents that the expense has been reconciled, and is no longer hanging over the business.
Add prepaid expenses
Anything your company has to prepay for, such as rent on office space or business insurance premiums, is considered a prepaid expense. These items are considered assets and are slowly drawn down as they are exhausted over time.
Add accounts receivable
Accounts receivable represent any outstanding sales agreements or invoices submitted to clients. Until they are reconciled with a cash payment, they are considered an asset to the company.
Subtract cash receipts
Once an invoice is paid, it goes from being a receivable to being a liquid asset. By subtracting cash receipts from accounts receivable, it acts as a double-entry to confirm payment was made and is now in the cash account.
Subtract customer prepayments
Anytime a customer prepays for a deliverable, it becomes a short-term liability for your company instead of an asset. Subtracting customer prepayments shows how much work is currently outstanding, as opposed to a cash sale for work needing to be completed.
Common hiccups when converting from cash to accrual accounting
Making the change from cash accounting to accrual accounting isn’t an automatic process. The transition requires careful planning on many levels, from accounting software changes to balancing procedures.
One of the most common hiccups when changing from cash accounting to accrual accounting is managing double-entry bookkeeping. With cash accounting, everything is added into the ledger in real-time. But with accrual accounting, each transaction must be entered twice to ensure balance. When making the shift, it’s important to ensure that not only is everything input correctly, but that each accounting period is adjusted so that the book balances at closing time.
Another common hiccup is in timing the conversion. Because corporations and partnerships must file an announcement with the IRS when changing directions, it isn’t as simple as moving from one method to the other overnight. Instead, companies should consider aligning the transition at the beginning of their next fiscal year, or adjusting their fiscal year to coincide with the change, so that the next tax year can run smoothly.
Finally, while most accounting software allow companies to use either method, it isn’t an automatic shift for most. As your company makes the move, talk with your accounting team to understand how to make the shift in your software of choice, and how much work it will take to make the transition.
Changing from cash to accrual accounting isn’t an easy process, but understanding the difference between the two and how to prepare can help your company shift into your next phase. Making the shift can open new opportunities with investors, partnerships, and other potential new ideas.
The hiline team loves to help companies take their finances to the next level, with cloud-based accounting packages designed for your business. Contact us today to get started on setting your path to fiscal success.
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