Accounting For Startups – How To Lower Your Tax Liability

Written by Baixue Ma, Tax Lead, airCFO

As a startup founder, you know cashflow is the lifeblood for your business.  But did you know that the accounting method you choose can have a significant impact on cash flow and tax liability? 

In this article, we share how startup founders can significantly reduce their tax liability by converting from accrual accounting to cash basis accounting.  

You’ll learn:

  • The difference between cash accounting and accrual accounting 
  • Who can use this conversion (and who can’t) 
  • How to get help, if you need it

Cash Accounting vs Accrual Accounting

Cash accounting, also known as cash-basis accounting, is an accounting method where payments are recorded when they are received, and expenses are recorded when they are actually paid.  

Accrual accounting, on the other hand, recognizes revenue when it’s earned and expenses when they are billed (but not paid).  

Which Method Should You Use?

Small businesses often use cash accounting because it is simple and straightforward and provides a clear picture on how much cash the business actually has on hand.  However, accrual accounting can help you better leverage your cash position and maximise your operational abilities by spreading your revenue recognition and receivables. 

For some companies, it can be financially advantageous to consider using both methods. For instance, depending on your business structure and stage, you may use accrual-based accounting for ongoing financial analysis, but choose to convert the books to a cash-basis for IRS and tax purposes if it lowers your tax liability. 

Having said that, depending on your startup’s stage and structure, you may be required to use the accrual method. For example, you are required to use accrual accounting if your startup has gross receipts greater than $25M in the tax year. 

Not sure which method you could – or should – use? We can help.  Book a complementary call here and let’s talk about it. 

How To Convert Your Accrual Accounting to Cash Accounting

To convert your journal entries from accrual basis to to cash basis, follow two steps:

#1 – Roll Retained Earnings

To start, make sure the prior year ending retained earnings balance on your balance sheet is the same as the current year beginning retained earnings balance.

#2 – Convert Entries from Accrual to Cash Basis

Next, convert your journal entries from accrual basis to cash basis, where applicable. For most cases, you will only need to convert the following: 

  • Accounts Receivable (AR) 
  • Accounts Payable (AP) 
  • Accrued expenses 
  • Prepaids 

See It In Action 

To illustrate, let’s assume you’re preparing your taxes, with the tax year ending December 31, and you are converting your books from the accrual basis method to the cash basis method for the first time. 

Using accrual based accounting your trial balance shows: 

 

Year 1 – Accrual Based Trial Balance

Item  Value  Related to 
Prepaid Expenses  12 Rent 
Accounts Payable  10 Taxes 
Accounts Receivable  50  Sales
Accrued Expenses  Insurance 

Now let’s look at these same numbers, converted to cash-based accounting 

 

Year 1 – Accrual-to-Cash Journal Entries

Debits  Credits 
Rent  12 Prepaid expenses  12
Accounts Payable  10 Tax Expense  10
Sales  50 Accounts Receivable  50 
Accrued Expenses 5 Insurance Expenses  5

The biggest benefit from these journal entries is reversing sales income of $50, deferring the recognition into Year 2.

Now let’s look at Year 2.  Remember to check if your retained earnings are rolling on an accrual basis first.

 

Year 2 – Accrual Based Trial Balance

Item  Value  Related to 
Prepaid Expenses  36 Rent 
Accounts Receivable   240 Sales

 

Year 2 – Calendar Year Accrual-to-Cash Journal Entries

Debits  Credits 
Rent  36 Prepaid expenses  36
Sales  240 Accounts Receivable  240

Again, the biggest benefit from these journal entries is reversing sales income of $240, deferring the recognition into Year 3.

Now that we’ve done this conversion, we have a second step for accrual to cash journal entries: reversing all the prior year accrual to cash journal entries to recognize the entries as revenue or expense, because in theory cash should have been received or paid in Year 2. 

So now, we make these additional journal entries: 

 

Year 1 – Accrual-to-Cash Journal Entries

Debits  Credits 
Retained Earnings  12 Rent Expense  12
Tax Expense  10 Retained Earnings  10
Retained Earnings  50 Sales 50 
Insurance Expense  5 Retained Earnings   5

 

With the knowledge now in-hand about cash and accrual accounting, we’d challenge founders to think which is best for them at their current stage. Still have questions about what accounting method is best for your startup at it’s current stage or how changing your accounting method might effect your tax liability? Feel free to reach out and schedule a discovery conversation here.

Author Note: Baixue leads up the tax team at airCFO. She is a CPA with extensive experience advising startups, and previously worked in a regional CPA firm and a Big 4.

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