What are accounting and bookkeeping?
Startup founders generally know that they need some form of accounting and bookkeeping, but the difference between them (and why their startup might need one service but not the other) isn’t obvious to many founders. Sometimes founders are so focused on their startups’ mission they think that this process isn’t worth the worry, and they should figure it out later, but ignoring the need for recording finances can be very dangerous.
Startups, at a basic level, try to capture value in the form of revenue by selling products and services to customers. To illustrate that value capture, transactions need to be recorded and presented. But how a transaction is recorded and presented is the critical difference between bookkeeping and accounting.
The difference between bookkeeping and accounting
Bookkeeping is the process of recording all of the company’s transactions in a set of books, also known as a ledger. Entries are recorded in accounting software, which will compile reports based on how bookkeepers tag such entries. It is a necessary step in the accounting process, but it may fall short depending on the needs of a business.
Accounting is the process of contextualizing each transaction in order to present an accurate picture of the company’s financial performance. Accountants go beyond recording a transaction; they interpret how each transaction impacts the financial status of the business.
Another important distinction between bookkeepers and accountants is that accountants are well-trained stewards of accrual-based accounting, which is required by Generally Accepted Accounting Principles (GAAP). Accountants can create financial reports on both an accrual-basis or cash-basis, while bookkeepers will usually record transactions only on a cash-basis.
Accrual-based accounting recognizes revenues and expenses as they are incurred in accordance with the matching principle. In contrast, cash-based accounting records expenses and revenues as they are paid in order to keep an accurate record of cash on hand.
Why does the difference matter?
An entrepreneur should care about this because the two processes provide different answers to questions such as:
- How much do customers owe me?
- How much do I owe my vendors?
- How much does it cost to run my business?
- How much do I earn on each sale?
As an example, here’s how an accountant and a bookkeeper would look at revenue:
Your business builds a prototype, founders contribute $5,000 in cash, and the first sale for a $12,000 annual subscription is closed and collected on the first day of the month. This is great news. At the end of the month, the business has $17,000 in the checking account. Accounting software needs to reflect this cash balance by recording this transaction. What is the process to accurately represent the business’ value capture?
A bookkeeper records this payment in the general ledger as revenue that increases your cash balance. Accounting software would present monthly sales of $12,000 and a cash balance of $17,000. Presenting it this way may be misleading since that revenue will be earned over twelve months, not one.
An accountant seeks context about the transaction (or the bookkeeper’s general ledger entry), and learns that the upfront payment is actually revenue that will be earned over the next twelve months. Therefore, the accountant creates entries in the accounting software to illustrate only $1,000 of revenue for the month, and $11,000 as an unearned revenue liability. In this case, cash is still $17,000, but now revenues are recognized when earned, and a liability is created. This liability (i.e. the obligation to provide the service) exists to offset the increase in cash value since the business can’t claim value creation if it’s unearned in that period.
In other words, one seemingly simple transaction can be interpreted and presented in ways that produce different values for a business.
To understand more about how accounting and bookkeeping differ, let’s take a look at some key accounting terms and principles.
Companies usually reconcile and close their books on a monthly basis. The outcome of this process is the production of financial statements. In order to prepare financial statements, however, each transaction must be recorded into a ledger of accounts that is comprised of primarily five categories:
- Assets—what you own, such as inventory, accounts receivable, and cash
- Liabilities—what you owe to those entities or individuals that are not shareholders, such as accounts payable and debt
- Owners’ equity— the shareholders’ claims on the business, the book value (as opposed to market value) of which is equal to assets minus liabilities
- Revenue— the value of what you sell to customers
- Expenses—the costs incurred to sell your products to customers
These categories are the building blocks of the following financial statements:
An income statement is meant to illustrate how much revenue you generate in relation to the expenses incurred during that period. The income statement shows if your business activities generate a profit or a loss.
Your balance sheet lists the value of your assets, liabilities, and stockholders equity. This document provides the snapshot of your business’ net worth and ensures that the accounting equation holds true:
Assets = Liabilities + Stockholders’ Equity
The cash flow statement reconciles the beginning cash balance to the ending cash balance by illustrating the sources and uses of cash from operations, investing, and financing activities.
The statement of stockholders’ equity shows how shareholder claims changed during the period.
In the example above, a business started with $5,000 in cash, no other assets, and no liabilities, and thus it created $5,000 of stockholders’ equity. The accounting equation holds:
Assets ($5,000) = Liabilities ($0) + Stockholders’ Equity ($5,000)
Once $12,000 was collected, the bookkeeper increased cash and increased revenue. This means cash increased to $17,000, and stockholders’ equity increased to $17,000
Assets ($17,000) = Liabilities ($0) + Stockholders’ Equity ($17,000)
The accountant interpreted this differently. Indeed, cash increased to $17,000, but an obligation to provide a service for the next twelve months was created, which in accounting-speak is a liability. At the end of the month, the business earned 1/12th of that revenue, but is still obligated to fulfill 11/12ths of their contract. This means the stockholders’ equity only increased by the amount the business earned:
Assets ($17,000) = Liabilities ($11,000) + Stockholder’s Equity ($6,000)
The set of financial statements prepared by a bookkeeper on a cash basis says the business is worth $17,000. The set of financial statements prepared by an accountant on an accrual-basis says the business is worth $6,000.
Does my startup need accounting, bookkeeping, or both?
Founders often make the mistake of waiting to reconcile accounts or interpreting each transaction’s impact on financial health. Who can blame them? A high growth company is focused on its mission, not the nuances of assets and liabilities. But procrastinating or ignoring these requirements can be costly to correct at best and fatal to the business at worst.
As soon as a business starts spending or receiving money, bookkeeping becomes an important piece of the puzzle. It’s much easier to start out correctly with everything reconciled than it is to make sense of a company’s finances after 500 transactions. Even if a business is simple and small, it’s important to keep accounts reconciled since the IRS requires a representation of financial performance for the year.
Bookkeeping is also a crucial piece of maturing into investor-readiness. Investors require an accurate, up-to-date, and clearly-interpreted set of financial records before they consider putting money into a business. Investing time, effort, or money into bookkeeping is a critical first step to present accurate financials to secure investment.
As businesses grow in revenue, transactions, or people, an accountant becomes more important. They add clarity to financial reports by interpreting transactions in a way that more accurately represents the value of the business and business activities. Accountants can certainly become key team members, and are frequently available as freelance or part-time advisers. However, an early-stage startup may not necessarily need a full-time accountant in the early innings.
Accounting software gives bookkeepers more insight
It’s important to understand the availability of and improvements in accounting software, such as Xero. This software automates some of the work that previously required a bookkeeper. Now, bookkeepers are likely to perform some work that could be considered accounting as part of their bookkeeping fee. In addition, some bookkeeping firms, such as Simplexity, also offer outsourced accounting services to growing companies.
As a founder of a high-growth startup, understanding how to administer your books may feel secondary at first. But your books serve two critical functions: 1) to accurately represent your business’ ability to capture value for shareholders, and 2) to ensure you have enough liquidity to fulfill your mission. Most early-stage startups should keep their accounts up-to-date, and we suggest paying a bookkeeping service to begin recording transactions and reconciling accounts. But when a startup’s business activities become complex enough to warrant frequent interpretation, founders should seek advice from an accountant sooner rather than later, especially if they are fundraising.
This article is intended for informational purposes only, and doesn't constitute tax, accounting, or legal advice. Everyone's situation is different! For advice in light of your unique circumstances, consult a tax advisor, accountant, or lawyer.