Accounting For Startups: A Step-by-Step Guide

Accounting: For Startups. The Guide.

TL;DR

Accounting is important.

You should be using accrual accounting.

Bookkeeping is not accounting.

Select the right accounting system.

Know the basics of setting up your Chart of Accounts.

Understand what your options are for help.

‍First, why is quality accounting important for every startup?

Tax Compliance. Your books have to be in order so that you can file taxes at year end without a major headache. If you don’t have a good system to track assets, liabilities, equity, income, and expenses - good luck.

Business Planning. Good accounting practices set the foundation to make better decisions moving forward. Maintaining quality accounting practices helps you understand your transactions and revenue and ultimately informs your long-term strategy. Strive for consistency and comparability.

When should my startup start focusing on accounting?

Day one. Seriously. C'mon now, you're talking to an accountant... Your goal should be to produce consistent and comparable financials. Particularly if you're looking to bring in outside capital, you should be prepared months ahead of approaching institutional investors.

Investors’ due diligence is designed to validate your traction, check your organization, and ultimately drive towards valuing your business. Poor accounting can lead to a deal falling apart— while a polished accounting & financial reporting package may be able to demonstrate your well-thought out plan. It's all about financial health.

Note: at the angel or seed stage (pre-revenue) – investors are looking at the founder and their product, the financial model is nearly 100% assumption-based and the accounting package is less relevant to securing investment.

What’s the difference between cash and accrual accounting?

Cash basis/tax basis accounting tracks when cash was received. Cash basis accounting recognizes income when cash is received and recognizes an expense when cash is paid. It is the foundation of accounting for tax purposes and fine for most small independent businesses. 

Accrual basis accounting aligns revenue and expenses with services. Accrual basis accounting recognizes revenue paid for services whenever those services are delivered–regardless of payment date. So if you are paid upfront for a service delivered over 12 months, the recognition of that revenue is amortized over the 12 months as the service is delivered. 

Investors, banks, and outside parties will generally require accrual accounting. All publicly filing entities are required to use accrual accounting and investors expect it to show them how and when revenue is earned, how contracts are structured, and provide them more clarity over key financial metrics.

What’s the difference between bookkeeping and accounting?

Bookkeeping is the basic process of categorizing transactions. Bookkeeping entails tracking transactions throughout the month and bucketing them into an account on your balance sheet or profit and loss statement. It is the foundation layer for good accounting.

Good accounting adds a layer of sophistication and intelligent assumption onto transaction data.  Accounting entails added synthesis of the transaction data, including how transactions impact financial reporting, the relationships between accounts, how various expenses may drive revenue, or the nuances between cost of goods sold and operating expenses.

From a role perspective:

• A bookkeeper categorizes transactions. At a basic level bookkeepers take transactional information and ensure it gets into the system.
• An accountant makes more intelligent assumptions based on data. Beyond filing data, accountants make assumptions based on your financials and help make sense of how and why transactions are codified the way they are.

How do you select an accounting software?

Start with an entry-level accounting software (e.g. QuickBooks Online, Xero). These cloud-based  systems will be enough to get you through several rounds of capital. They offer the ability to manage all aspects of your financial records, generate basic financial reporting, organize receipts, track inventory, facilitate payroll, and the option to bolt on additional integrations. Accounting needs will vary, but this is a great start for startup accounting.

You should integrate your other data sources to your GL of record. Any outside tool used for billing, payroll, invoicing, etc. should be seamlessly integrated with your ERP software:

• CRM (e.g., Hubspot, Salesforce, Pipedrive, Copper)
• Payroll (e.g. Gusto)
• Bill Processing (e.g. Bill.com)
• Bank account feeds and credit cards (e.g. Mercury, Brex, Rho, Arc)
• Inventory Management Software (e.g., SOS, DEAR)
• Recurring billing tools (e.g., Recurly, Chargebee, SaaSOptics)
• Document management tools (e.g., DocuSign, PandaDoc)
• BONUS: If you're preparing pitch decks - you have to check out Beautiful.ai. Big fan over here.

As you get larger or your accounting gets more complicated, you might graduate to a more robust ERP solution (e.g. NetSuite, Microsoft Dynamics) – the need may be triggered by an increase in complexity or scale: 

General Complexity triggers

• Multi-entity consolidation
• International / multi-currency transactions
• Transaction volume and workflow needs
• More sophisticated approval-levels

General Scale triggers

• At $15-20M in revenue for tech companies
• At $8-12M for manufacturing companies

What are some of the key steps in setting up your accounting system?

First Step: Set up your chart of accounts. It should be tailored to your business and offer a better view into P&L on the cost of goods sold vs. expenses. Set it up to categorize items as necessary for internal performance and tax purposes. 

Step 2: Integrate bank accounts and credit cards. You want all transactional activity to flow directly into the system. Bank and credit card feeds will automatically sync with your GL data.

Step 3: Integrate billing and invoicing systems. If you are not billing directly from the system, you want direct integrations to make sure every invoice that goes out is attached to its transaction.

Step 4: Map uncategorized transactions to your chart of accounts. Map historical data to the new chart of accounts so that it will be accurate when imported. Bank and credit card transaction data should be imported when it’s linked and may need to be categorized.

Step 5: Establish a cadence for inputting, categorizing, and month-end close. Inputting bills and categorizing transactions can be done weekly or monthly but establishing and sticking to a regular cadence will drive consistency. Establishing a month-end closing process is important so that you can close your books and limit retroactive changes. You want to limit alterations of historical information as they materially diminish the value of your financial reporting efficacy. It's all a part of good accounting hygiene!

How do you establish a chart of accounts?

The goal is consistency. A chart of accounts should be used to enable consistency of data and comparability of your financial statements over time. Ensure that as you establish your chart of accounts, you cover all key drivers of your business - full list below.

Begin with an expansive list and then drill down to a concise chart of accounts that suits your business needs:

• Cash/Cash Equivalents (Checking, Savings, Money Market, Liquid Investments,)
• Accounts Receivable (Trade AR, Allowance for Doubtful Accounts)
• Other Current Assets (Prepaid Expenses)
• Non-Current Assets (Property, Plant, & Equipment, Notes Receivable, Intangibles)
• Current Liabilities (Accounts Payable, Credit Cards, Accrued Expenses, Short-Term Deferred Revenue)
• Non-Current Liabilities (Notes Payable, Convertible Notes, Long-Term Deferred Revenue)
• Equity (Common Stock, Preferred Stock, Options, Retained Earnings)
• Revenue
• Cost of Goods Sold
• Operating Expenses (G&A, Sales & Marketing, R&D, Other)
• Other Income & Expenses (Interest, Depreciation, etc.)

Account numbering is fairly standard in accounting, but naming conventions may vary. Naming of accounts will depend upon your company’s specifics (e.g., various income line items refer to particular service offerings). Numbering conventions are generally constructed this way:  

• 10000 – Assets
• 20000 – Liabilities
• 30000 – Equity
• 40000 – Income 
• 50000 – COGS
• 60000 – OpEx
• 70000 – Other

How do you categorize and attribute revenue and cost of goods sold?

If you have multiple service offerings/revenue drivers, categorize them separately. For example, in a contract with implementation, warranty, and service components, recognize each independently so that you can match them with costs of goods sold in order to track margins and true recurring revenue. Ideally, you should also spell out separate revenue drivers in the customer contract.

Think about your future state of how your services will be structured. Set up your chart of accounts for future state instead of building the plane while you fly it. You want your financial reporting to articulate the drivers of profitability within your current offerings as you think about future offerings.

Revenue recognition based on customer contracts is governed by ASC606, and is subject to:

• Identifying the performance obligations in the contract
• Determining the transaction price in order to service the performance obligations

How should you think about revenue recognition?

In accrual accounting, match revenue to the period in which the service was rendered. Revenue from annual contracts is recognized on a monthly pro-rata basis. So, if you’re paid upfront for a year-long contract, recognize 1/12th of the total amount each month. Similarly, if you incur an expense that spans multiple time periods (months or years), you may need to record a prepaid expense and recognize the expense during the period in which the expense is incurred.

How should you think about inventory?

Recognize revenue when the product is sold. Depending on your contract, the sale can occur when you transfer goods from you to a carrier, or when a carrier delivers it to your customer (FOB Shipping Point vs FOB Destination).

First-in-first-out is the gold standard. Accrual accounting allows for First-in-First-Out, Last-in-First-Out, or a weighted average cost methods for inventory accounting. FIFO is particularly preferred with inventory that has a useful life. If you are not able to offload aged inventory, and will need to write it off. 

What kind of forward-looking model should you build, and how should you update it with actuals?

You can use Excel/Sheets or an easy-to-use modeling software (which can be more user-friendly).  Tools like Finmark, Forecastr, and Pry are less reliant on excel wizardry and built more on intuition - these softwares facilitate building readable but complex models that include scenario analysis, long-term planning, cash forecasting, and many other benefits.

A basic financial model should include 3 statements. Actual data can be pulled on a monthly or quarterly basis and used to update your financial model using these 3 statements:

• Balance sheet
• Profit and loss
• Statement of cash flows

A financial model will include a series of base assumptions. A forward-looking model will be assumption driven and will include your best growth estimates and estimated conversion rates. Use assumptions to project things like:

• Revenue growth
• Introduction of new products
• Hiring new employees

A more sophisticated financial model can include complex assumptions to appropriately account for anticipated events: 

• Scenario analysis
• Sensitivity analysis
• Headcount planning
• Seasonality planning

What are different third party resources that you might leverage, and what is each?

Bookkeeping-centric options. e.g. Pilot, Bench, QuickBooks Certified Accountants, among many others – will categorize transactions, close the books and export financials at the end of the month – typically on a cash basis. They typically offer basic outputs with very little insight into methodology, strategy, or communication. 

Note: be mindful of ‘the who’ when choosing a bookkeeping service, make sure you have a direct contact established that will be delivering the services (ideally US-based).

Outsourced bookkeeping + accounting. On top of the bookkeeping basics, outsourced accounting resources can generate  financial reporting, real-time dashboarding features and forward-looking metrics. When you need to uplevel your financial reporting, ensure you have a quality accountant behind the work that is able to interpret the why behind your numbers.

Full-stack/CFO resources. This could be a former CFO who is consulting on the side, or a full-stack CFO you can hire on a fractional basis. Someone with CFO-level experience should handle more complexity around things like long-term strategy, equity transactions, or M&A — advising at a strategic level.

Tip: Remember that the leadership team is still responsible for strategic decision making. Most resources will equip the founders with data used for decision making. Outsourced CFOs offer more of a partnership approach to strategic guidance but it’s still important for the leadership team to maintain a tight relationship with financials.

When you’re ready to start to hire an internal team, who do you hire and in what order?

Take a bottom-up approach. Hire at the transactional level first then build a team on top of the transactional layer. Start with a bookkeeper or accountant, then a controller, and finally a CFO. If you start with a CFO hire, they may be unwilling to get into more menial work and may be further removed from the day-to-day details. Here’s what you could be expecting in today’s market:

Accountant or Senior Accountant

Background: Accounting degree and worked 3-5 years in public accounting in audit or tax 

Salary Range: $70K-$95k base salary + incentive compensation

Controller

Background: 5-15 years of experience in a mix of consultative and industry background

Salary Range: $110K-$170K base salary + incentive compensation

Salary range depends on background, responsibilities and complexity of business profile.

CFO

Background: 10+ years of experience, inclusive of Controllership, specific industry, or accounting firm backgrounds

Salary Range: $200k+, exclusive of equity incentives

Industry experience is key. But outsiders could be a fit if they provide value from a creative thinking perspective (i.e., an investment banking background if you plan to be acquisitive).

What are the most important pieces to get right?

Set your system up based on your anticipated future needs. Build your systems in anticipation of growth or you will spend a lot of time and money right-sizing in the future.

Get high-quality outside advice. Seek input from investors, advisors, and peers. Most service providers are willing to hop on a coaching call and give some advice. 

What are the common pitfalls?

Don’t neglect accounting. By not focusing on your accounting responsibilities early - you risk significant rework, cleanup, and cost to make up for prior neglect moving forward. The best time to get serious about accounting is yesterday.

Don’t overlook data hygiene for reporting. System integrations and transactions flowing into your chart of accounts, it’s important to ensure congruence and hygiene in data management. 

So, what have we learned?

First and foremost, accounting is important for startups. You should be using accrual accounting from the beginning to help you make sound financial decisions. Additionally, it’s important to use a great accounting system that will create consistency, comparability, and begin to automate many of the bookkeeping tasks for you.

Are you feeling overwhelmed? Don’t worry – we’re here to help! Reach out to our team today for assistance getting your business on track financially. Thanks for following along – stay tuned for more helpful content coming soon!

howdy@fullsendfinance.com

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