How To Implement The Accrual Accounting Method In Your Startup

Understanding your startup's finances can be a daunting task, especially if you're new to concepts like "accrual accounting."

But it's a critical aspect that could shape your business's overall performance.

Accrual accounting gives you a better picture of your financial status than cash accounting.

This process can offer sound insight into your future profit margins and expenses. It operates on an entirely different logic: It records financial transactions when they're incurred, not when cash changes hands.

This article will take you through the process of implementing accrual accounting in your startup, ensuring that even the most accounting-adverse founder can grasp this essential financial concept.

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What Is Accrual Accounting?

Often misunderstood, accrual accounting records revenues and expenses when they are incurred, no matter when cash is exchanged. If a sale is made or a bill is received, it's recorded immediately—not when payment is received or made.

This approach can provide stronger fiscal analysis and strategic planning possibilities, proving to be advantageous for startups looking for growth and financial clarity.

For example, with accrual accounting, revenue counts for December if you provide a service in December but don't receive payment until January. 

This technique lets you see exactly when transactions occur and better plan for future expenses and income. It is also worth noting that companies with average revenues of $25 million or more over three years are required to use accrual accounting.

Must read: Start filing form 1120

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Difference Between Cash and Accrual Accounting

Cash and accrual accounting methods differ greatly.

Under the cash accounting method, income and expenses are registered only when money is actually received or paid.

In contrast, accrual accounting recognises transactions as soon as they happen, regardless of the cash flow.

For instance, a service provided in a specific month is recorded in that same month—irrespective of when you actually get paid. The ability to capture real-time financial snapshots can significantly help startups strategise their business plans and growth management.

For startups with uneven cash flow or cyclical sales, accrual accounting becomes particularly valuable, as it presents a more accurate representation of the company's financial health at any given moment. 

However, it might be noted that accrual accounting demands a steeper learning curve and requires diligent updating.

Stakeholders tend to rely on this form of accounting as it offers a practical view of finances, thus providing clearer indicators for investment and strategic planning regardless of cash flow issues.

Related reading: Double entry vs Single entry accounting: Top Differences

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Advantages and Disadvantages of Accrual Accounting

Accrual accounting comes with its pros and cons. On the plus side, it allows for:

• Accurate financial snapshots
• Better strategic planning
• Enhanced predictability

Limitations, however, include:

• Increased accounting complexity
• Higher learning curve
• Need for stringent record-keeping

Understanding these pros and cons allows you to make an informed decision about whether accrual is the right accounting method for your startup. 

What are the Key Elements Of Accrual Accounting?

Accrual accounting relies on numerous essential components. Among them are:

Revenue Recognition

Revenue recognition dictates that income is reported in the financial period it is earned, regardless of when actual payments are made. This means that if you provide a service or sell goods, the earnings from these are recorded as revenue as soon as the delivery is completed, even if payment will be received in the future. 

This facilitates a more accurate recording of your startup's overall financial performance within a specified period.

For example, suppose you provide a service in January, but the customer doesn't pay until March. With cash accounting, this income would show in March. But in accrual accounting, you would register the income in January itself. 

This allows a more accurate representation of income and expenses in the period they are truly earned or incurred, providing you with a comprehensive view of your startup's profits, losses, and cash flows during a specific fiscal period.

Expense Recognition

Expense recognition is the other side of the ledger in accrual accounting, just as pivotal as revenue recognition. It stipulates that expenses be acknowledged in the period they occur, regardless of when they are paid. This can further amplify the clarity of your financial standing.

For instance, a cost incurred in February can be recorded in your February financial documents, even if the payment is postponed to a different month. This way, your financial commitments align chronologically with related income. This method, also known as the matching principle, provides a clear link between costs and the revenue they generate, improving the reliability and relevance of your financial information.

In the case of any tangible asset acquisition, such as office equipment, accrual accounting enables depreciation over its useful life, tying the expense back to the periods it benefits.

Hence, the accrual system paces earnings and expenditures suitably in their respective periods, making it an effective tool in reflecting the actual situation of your startup's finances.

Accounts Receivable and Payable

Two fundamental elements of accrual accounting are Accounts Receivable and Accounts Payable.

• Accounts Receivable track all the money that is owed to your startup by clients or customers, reflecting these earnings even before they hit the bank.
• Accounts Payable refers to the money your startup owes to suppliers, which might not have been paid yet but are accounted for based on when the expenses occurred.

Essentially, these elements help provide an accurate, real-time picture of your startup's financial state for better decision-making.

This continuous and dynamic view of your startup's financial balance allows you to identify trends, foresee implications, and plan cash flows more effectively. By pinpointing exactly when incentives and liabilities are anticipated upon providing or receiving services, you're better equipped to steer growth, mitigate risk, and manage expenses.

However, professional expertise may be required to establish and maintain this intricate operation—rather than focusing on monetary transactions alone, a firm grasp on the critical pulse of financial prompts and responses that drive your startup becomes essential.

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How to Transition to Accrual Accounting?

Transitioning to accrual accounting can initially seem daunting, but a planned approach can make it manageable. Here are the steps you may consider:

• Begin by understanding essential accrual terms like income recognition and expense recognition.
• Learn how to manage Accounts Receivable and Payable.
• Track pending bills from suppliers, even if not paid, as part of Accounts Payable.
• Record payments due from customers under Accounts Receivable.
• Consider engaging an accounting professional for guidance and support.
• Ensure that revenues are recorded when services are performed or goods are delivered, regardless of when payment is received.
• In the same vein, do remember to recognise expenses when they occur rather than when the payment is made.
• Keeping up with accrued revenues and expenses regularly benefits the startup's financial integrity and comprehensive planning.
• Train your staff or consider outsourcing if the process seems too complex.
• Regularly review your accounts to stay informed about your state of finances.
• Adopt a comprehensive approach, considering both short-term and long-term benefits.

Upcoming feature: Inkle Books, an automated, founder-focused accounting software, is about to roll out a financial reporting feature that supports accurate accounting. Look for this addition, which is specifically designed to simplify and streamline your accrual accounting processes.

Let’s Recap!

There you go—we've covered the essential elements of accrual accounting and provided you with a roadmap for transitioning to this method of financial management. The concepts of Revenue and Expense Recognition, along with Accounts Receivable and Accounts Payable, are key components. With the accrual method in place, you get: an accurate and real-time representation of a startup’s financial situation, allowing better decision-making. 

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