Read any startup blog and you’ll get to the cash vs. accrual article soon enough. Traditionally, this question of choosing either the cash basis method of accounting or accrual accounting has been posed to new business owners as if it was a one-and-done decision—choose now and forever hold your peace.
Cash basis is easier to do—simply record the income when cash is received, and expenses when they are paid. All you need is a business bank account and a basic QuickBooks subscription for that. Need something more sophisticated? The accrual method lets you record income when it’s earned and expenses when they’re incurred.
The reality of business growth demands a more nuanced approach to choosing an accounting method. In fact, it shouldn’t be an either-or question at all, says Brad Shaver, director of outsourced accounting for XMI: “It’s not, ‘Cash or accrual?’ It’s ‘Which parts of each of these methods help give your business the right visibility at the right time?’”
For early stage companies that are still determining if they have a viable business idea, cash basis accounting is enough, he says. But as you expand and want better insights, there’s a confluence of cash basis and accrual basis informally known as “modified cash basis” accounting that the majority of small- to mid-size companies utilize.
“While this doesn’t formally exist in any college accounting textbook, oftentimes business operators will elect to track certain things, primarily accounts receivable and accounts payable, through accrual, but leave the rest to cash basis,” he says.
Defining Modified Cash Basis Accounting
It’s hard to nail down a definition for modified cash basis accounting because it will look a little different for each company.
“There’s no single definition,” Shaver says. “It’s a fluid accounting method based on what is meaningful and significant to your particular business. You know cash accounting isn’t going to give you enough detail and accrual is way too much effort if you aren’t being required to do it. We don’t even use the term—it just turns out that way.”
For example, if you don’t have many prepaid expenses or they’re not large, those can be rolled into your cash basis accounting. For example, if you pay your insurance six months in advance, it doesn’t make sense to record a prepaid and expense the insurance over six months.
When It’s Time to Evolve Your Accounting Method
But there may come a time when line items you used to record in the cash column need to move to accrual. “Choosing the right option at the right time can make the difference between actionable insights and worthless data,” Shaver says. Here are some scenarios that could require your accounting method to evolve:
Your business is viable: When testing a market or business idea, cash basis accounting is probably sufficient. But as soon as you decide your business is viable and ready to move to the next level, your accounting method should evolve with it.
Outlier line items: Think about expensive subscriptions and software licenses for your team, or a long-term project that pays out unevenly. Without accrual accounting, you could look at your profit and loss statement in the wrong month and easily read things the wrong way.
Mandatory requirements: Taking on debt or undergoing an audit can be events that require moving your financials to the accrual method of accounting.
Planning an exit: If you plan to sell your business, you should consider adopting the accrual method, which gives the most insight into the financial performance of a business and illustrates an enhanced level of sophistication.
Need help deciding which accounting method is right for you? XMI can help you navigate this process regardless of the stage of your company. ““We can scale with need and sophistication,” Shaver says. “Our goal is to help you find the goldilocks method of accounting.” Email email@example.com for additional information.