Startup Bookkeeping 101: Revenue Recognition

Let's take a brief break from the financial statements to discuss revenue recognition. Revenue can be recognized on either the cash or accrual Basis. Both are acceptable for management reporting, however generally speaking investors and other third parties require accrual basis as it is required under Generally Accepted Accounting Principles (GAAP). Future posts will discuss cash basis vs accrual basis in more detail but today we will focus only on the implications for revenue.

Cash Basis

Cash basis is the most basic and intuitive way of recognizing revenue. Revenue is recognized as cash comes in. If you collect $10,000 of payments in January your January revenue will also be $10,000. This method is typically used for side businesses and privately held businesses who are not otherwise required to report financial results on the accrual basis. The benefit of the cash basis of accounting is its simplicity. No calculations are required and the recordkeeping is much simpler. The cash basis can work well for service based businesses who bill and receive payment as services are provided. An additional benefit is forecasting cash flow is much simpler since your financial statements will already show when cash is received and paid to vendors.

Accrual Basis

The accrual basis of accounting is used by all companies required to report financial results in accordance with GAAP. This can include public companies, loan reporting requirements, and businesses required to report results to outside investors. The basic idea of the accrual basis of accounting is to align revenue and expenses with the period in which they benefit the company. For example, if a license is sold for $1,200 per year and the time period covered is January through December you would recognize $100 of revenue during each month of the year. The reason for spreading the revenue out over the year is to better reflect when the revenue is earned. If you are providing a license for 12 months it is more accurate to show the revenue is earned over 12 months than all at once when the invoice is paid. Expenses are treated similarly. If a sales conference occurring in September is paid for in July it makes more sense to record the expense in September as that is when the conference is actually occurring.

On the balance sheet we briefly discussed deferred revenue accounts. This is the intermediate account that makes the accrual method work. In our example above, if the $1,200 license was paid for in January your January balance sheet would show $1,100 of deferred revenue while your profit and loss would show $100 of revenue. This method of accounting is more accurate than the cash basis of accounting as it better reflects when revenues are earned and expenses incurred but it does make cash forecasting harder since you will need to make some adjustments to your financials to show when cash is actually received and sent out.

Which Method Should I Use?

Whether you use the cash or accrual basis depends on a number of factors. These factors include but are not limited to the size of your business and any third party reporting requirements you have now or expect to have in the future.

If you are simply running a side business and will never need to report your financials beyond your tax return the cash basis can make sense. It is much simpler and intuitive for individuals handling their own bookkeeping. This is especially true for service based businesses who have little if any Accounts Receivable.

If you have any third party reporting requirements that mandate GAAP compliant reporting it likely makes sense to use the accrual basis. You will save time due to having a single set of financial statements and if you are in this position you will benefit from the insights provided by the accrual basis.

QuickBooks Online and Accrual vs. Cash Basis

A final note for QuickBooks Online users. QuickBooks Online does allow you to toggle between the cash basis and accrual basis. However, in my experience there is some review needed if you are going from cash to accrual basis. The accrual basis of accounting requires extra mechanical steps that do not impact cash basis reporting but can cause issues if you are trying to toggle from cash basis to accrual basis. For that reason I recommend using the accrual basis of accounting as your default if you have any need for accrual basis financial statements rather than relying on the toggle option

Final Thoughts

The basis of accounting you choose can significantly impact the amounts shown on your financial statements and the choice should not be taken lightly. If you would like to learn more about which method is right for your business or would like to learn how Woodham Bookkeeping can improve your quality of life please feel free to reach out via the contact form.