Cash vs. Accrual Accounting: Make the Right Choice for Your Startup

Sally Sherman

Published January 31, 2024

Let’s keep it real. You founded a startup to build exciting products — not to rack your brain over the differences between the two main accounting methods: cash and accrual.

But it’s a pretty important part of doing business, so here we are.

The main difference between cash and accrual accounting is when you document expenses and revenue.

Cash-basis accounting records revenue and expenses when cash is deposited or dispensed from your bank account.

On the other hand, accrual-based accounting records revenue and expenses as soon as your business earns or incurs them.

In this guide, we’ll explain these two accounting methods and help you decide which one is better for your startup.

What is cash-basis accounting?

Under cash-basis accounting, your business records transactions when you receive or pay out cash. This means you’ll recognize income only when the payment lands in your bank account. The same goes for expenses, which you’ll record when you pay a bill, invoice, etc.

As such, cash accounting is a straightforward method that appeals to freelancers and small business owners because it doesn’t require complicated calculations.

But cash accounting isn’t without issues because it might not accurately reflect your financial health.

For example, if you sold products or provided services that haven’t been paid yet, your books won’t reflect these earnings. So, your business might seem in worse shape than it is.

Similarly, receiving a large sum could make it look like your business is doing great. But at the same time, unpaid bills might eat into a good chunk of this revenue.

What does cash-basis accounting look like in real life?

Let’s say you are a startup that provides video editing services.

In September, you wrap up a big client project and invoice them $10,000, with a 30-day payment term. The client makes the payment on October 15th. Using cash accounting, you would record that $10,000 as income in October, even though you earned the money in September.

Expense-wise, imagine you rent special video editing equipment for a one-off project.

The rental company invoices you $2,000 in September. You pay the bill on October 10th.

With the cash method, you wouldn't record the $2,000 expense in September, even though you received the invoice that month. Instead, you'd record the expense in October, when you made the payment.

When is cash accounting best for startups?

The cash accounting method is a good option for startups that operate on pay-as-you-go models. It provides a straightforward view of cash on hand, so it works well if you have limited transactions. However, not all business can use cash-basis accounting — learn why in the next section.

What is accrual-basis accounting?

Accrual-basis accounting records income and expenses as you earn or incur them, regardless of when money changes hands.

It uses accounts payable (funds you owe to other businesses) and accounts receivable (funds other businesses owe to you) to create a more accurate picture of your financial health.

However, this method is more complex because it requires careful record-keeping.

A key aspect of accrual-basis accounting is the matching principle. This means recording expenses in the same period as the revenue they generated.

For example, if you open a pop-up shop in September, you should record both the shop-related expenses and revenues in this month.

What does accrual-basis accounting look like in real life?

Consider a tech startup that hired a freelance developer in October to work on a new feature.

The developer sends an invoice totaling $3,000. Even if the startup doesn’t pay that invoice until November, they’d still document the $3,000 expense in October — because that’s when the freelancer did the work and the business incurred the expense.

Now, let’s say that the same startup offers a subscription to a podcast recording platform.

Customers can choose between monthly and yearly billing. If a customer signs up for a yearly subscription in December and agrees to pay $1,200 for the year, the company won’t record the entire amount in December when the customer pays for their plan.

Instead, they’d spread that income over 12 months. So, every month, the startup would recognize $100 in revenue, reflecting the service period to the customer.

What businesses are required to use accrual accounting?

In the US, some businesses are required to use accrual-basis accounting. If you check any of these boxes, you'll need to use the accrual method:

• Keep inventory (e.g., an e-commerce business)
• Offer credit to your customers (e.g., a hardware store that provides credit to construction companies)
• Exceed the $30 million limit in annual gross receipts averaged over the past three years

When is accrual accounting best for startups?

If you aren't required to use accrual-basis accounting based on the criteria above, it's still the best choice for many startups. (And, it's the best choice if you anticipating your businesses requiring it in the future.)

Accrual method accounting makes strategic planning easier. It provides a long-term perspective by including receivables and payables.

However, be careful with cash flow. Accrual accounting might depict a rosy financial picture with high income that you are yet to receive. And this can be misleading if cash flow is low.

Opt for accrual accounting if your business growth goals are ambitious — even if your company is just getting off the ground. Sooner or later, you’ll need to implement the accrual method. And it’s easier to do so when your business is less complex.

How to pick the right accounting method for your startup

Getting your startup off the ground is challenging enough. By selecting the right accounting method, you’ll have one less thing to worry about.

Here’s what to consider when choosing between cash vs. accrual accounting.

1. Growth plans

What are your goals for business growth? If you’re a small business that plans to stay small, the simplicity of cash accounting is a good choice.

But if you’re aiming for quick growth over a short period of time, the accrual method will better support these goals. Lenders and investors prefer it (more on that below), and it’s a legal requirement if you go over the $30 million annual gross receipt threshold.

Any startup that aims to become a publicly traded company should also consider implementing the accrual method. All public companies in the US must follow the generally accepted accounting principles (GAAP). It’s the standard for financial reporting and requires accrual-basis accounting.

2. Existing resources

Do you have the accounting resources to support accrual accounting? If not, opt for the cash method. It helps keep simple businesses lean and manageable because it's easy to track.

Once you have more resources, hire an accountant and implement an accounting platform that will make using the accrual method easier.

3. Business model

How does your business operate? The answer to this question impacts whether to go with cash or accrual accounting.

If your business operates on a pay-as-you-go model — meaning that customers immediately pay for services — the cash method makes sense. It’s simple and saves time because you don’t need to track receivables and payables.

But if your company has a more complex revenue stream, the accrual method is the way to go. For example, using the accrual method to match revenue with related expenses gives SaaS startup founders a better sense of the business’s profitability.

4. Lender and investor expectations

Unless your startup is bootstrapped, you’ll bring lenders or investors on board. Typically, they require accrual-basis accounting because it reflects actual financial activities, recording income when it’s earned and expenses when they’re incurred.

Depending on when payments come in, cash accounting can make your financials seem better or worse than they are in reality. So, it’s not hard to imagine why banks or investors aren’t fans of this method.

5. Taxes

Cash-basis accounting has tax considerations. Since you only record income and expenses when cash changes hands, tax liabilities can end up being deferred. In other words, you'll avoid paying taxes on income you haven’t collected yet.

However, the accrual method makes tax planning easier since it allows you to more precisely predict how much you’ll owe in taxes come April.

Why not choose both cash and accrual accounting?

While cash vs. accrual accounting might seem like an either-or scenario, it’s possible to use both.

With an automated accounting platform like Digits, it’s possible to keep books on an accrual basis while still getting a cash-focused overview of your finances. For example, you can access cash-related metrics such as gross income and net burn reports.

Even better, Digits reports use visual elements and real-time data to help you understand your finances — without getting a headache from staring at Excel models or PDFs. (Don’t worry, you can still export data to Excel.)

How to make the switch from cash to accrual accounting

Is your business ready to go from cash to accrual? Then, follow the steps below to get started.

Understand the implications

Switching from cash to accrual-basis accounting will make it easier to secure loans and investors. But there are also important implications for how you do taxes. Specifically, you’ll recognize income and expenses when you earn it.

As you make the switch, one major area of concern is the matching principle. According to Adam Olsen, the Accounting Advisory Services Practice Leader at consulting firm Embark, your main objective is to resolve differences in accounting records between the timing of actual cash payments and receipts versus when the actual exchange of goods and services occurred.

Olsen explains, “So, you need to get in line with the matching principle, where you match income and expenses within the same period in which they occurred. Completeness and cutoff principles become major players.”

The completeness principle requires that all financial transactions that should be recorded are included in the accounting records. For example, all sales and expenses up to the reporting date must be accounted for.

The cutoff principle states that businesses must record transactions in the correct accounting period. For example, any revenue earned in December but received in January should still be recorded in December.

File the appropriate paperwork

Once you decide to switch, file Form 3115 (known as the Application for Change in Accounting Method) with the IRS.

There are two ways to do so:

• Automatic: The most common one. Prepare two copies of the form and attach the original copy to the federal income tax return for the year you made the change. The other copy should be filed with the IRS National Office anytime between the start of the year of the change and the date you file your federal income tax return for that year.
• Non-automatic: It’s similar to automatic but only available to businesses that meet the eligibility requirements. There’s also a fee involved.

Get the right accounting solution for the job

The accrual method is easier with the right accounting platform.

Unfortunately, businesses often get stuck with accounting software that defaults to manual data entry and outdated tabular interfaces. So it’s no surprise that the industry standard is a close of two to three weeks — an eternity when you’re getting your business off the ground.

Digits can finalize your reports as early as the 5th of the month, allowing you to immediately share them with your investors. This is possible thanks to features such as AI-powered bookkeeping that automatically classifies transactions to save you time.

We trained our AI on double-entry accounting, so it’s able to take the data from bank accounts and credit cards to update and classify transactions in real time.

Each auto-booked transaction is reviewed by Digits’ team of Certified Public Accountants to give you peace of mind that the AI classifications are accurate.

Take control of your startup’s finances

Digits works with venture capital-backed startups to help automate their accounting and deliver instant financial insights. Sign up for a demo to learn how Digits can help you transition to accrual-basis accounting, take charge of your finances, and save an average of 10 days per month.

Cash vs. accrual accounting FAQs

Which is better, cash or accrual?

Accrual-basis accounting is a better option for startups and larger businesses because it provides a more complete and accurate picture of their finances. Lenders and investors also typically prefer (and often require) this accounting method. Cash-basis accounting is a good fit for very small businesses with limited transactions.

What is an example of cash and accrual?

If your business gets a $2,000 invoice from a vendor in September, accrual-basis accounting will record the expense in this month. Under cash-basis accounting, you will record it only when you pay it, which could be in October or November, depending on the payment terms.

Do most companies use cash or accrual?

The majority of companies use accrual-basis accounting instead of cash. It makes it easier to scale your operations and is preferred by banks and investors.