If you’re seeking SBIR grants, investors or other funding for your company, you understand the need for sound financial records. What you may not know, however, is the importance of accrual basis accounting.
If that term doesn’t ring a bell (or if that bell is ever so faint), we’re here to help.
What is accrual basis accounting?
When you started your business, you knew part of your work would be… well, business. Because while your passion is the product or service you developed, you still had bills to pay. So chances are you kept things as simple as possible when you set up your accounting processes.
For that reason, you likely established a cash basis accounting system. Under this method, income becomes taxable when payment is received by you. Expenses are deductible when they’re paid instead of when an invoice is received from a vendor.
The point of cash basis accounting is to track cash flow. It’s straightforward and easy to follow—perfect when your focus is on growing your ideas and products.
The accrual method, on the other hand, recognizes income when earned and expenses when incurred, regardless of when the payments are made or received. For example, you invoice a customer $10,000 for services performed in December. You receive payment for the invoice in January. Under accrual basis accounting, the entire $10,000 is recognized as revenue in December when the services were performed and the invoice sent.
The purpose of the accrual method is to follow the underlying economic transaction rather than just the flow of cash. It matches expenses to generated revenues to provide a more accurate measure of your profitability.
Why do I need to switch?
Banks and investors must consider not only the assets you have on hand, but future income as well. The same goes for expenses. For this reason, these funding sources prefer the clearer picture that the accrual method provides.
Let’s say you operate a technology company and this month you paid for software engineers to build an app for a customer. The app was completed by the end of the month, but the customer won’t pay until next month. Your end-of-month financial statements show a significant investment into the project with no revenue. Under the accrual basis of accounting, the revenue would be recorded as earned. This matches the timing of the expenses and portrays an accurate reflection of your profit on the project.
Here’s another reason to switch. If you’re going for an SBIR phase II grant, you’ll need to undergo an audit observing Generally Accepted Accounting Principles (GAAP). Since GAAP requires the use of accrual basis accounting, you’ll need to convert to this method. Preferably, this would be done at the beginning of the year to be audited.
When should I switch?
The short answer: it depends. It’s best to have accrual basis accounting implemented before you apply for SBIR grants or other sources of non-repaid funding. Switching accounting methods can take several months to implement and can also have income tax implications. You should plan accordingly to minimize any unwanted consequences. You’ll also likely need the help of a technology or manufacturing CPA, especially one that focuses on the needs of companies looking for grant funding.
The infusion of grant and investor funding is a critical step in the development of your startup. Make sure you have the accounting system required—and the help you need—to make this step a successful one.
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