Because of its more accurate matching of income and expenses, accrual-based accounting provides a more powerful analytical tool than cash basis accounting. Accrual-based accounting keeps better track of assets and liabilities than its alternative, making it easier to see where a business really stands. Despite these advantages, there are some drawbacks to accrual accounting.
Cash Basis Defined
To understand the pros and cons of accrual accounting, it is first helpful to consider the definition of its alternative, cash basis accounting. Under cash basis accounting, income is not recorded until the money is actually received and expenses are not recorded until the money is paid out. In contrast, accrual-based accounting records income when it is earned and expenses when they are incurred.
The cash basis of accounting is very simple, which is why many small and start-up businesses rely on it as their accounting method. Despite the simplicity of the cash method, it does a poor job of matching income with expenses. In addition, it is simply too easy to manipulate cash basis accounting. Income in January can be increased simply by holding December checks until after the first of the year and depositing them then. Similarly, expenses can be reduced by letting bills stack up until a more advantageous accounting period.
Accrual Is More Accurate
Because of its more accurate matching of income and expenses, accrual-based accounting provides a more powerful analytical tool than cash basis accounting. Accrual-based accounting keeps better track of assets and liabilities than cash basis accounting, making it easier to see where a business really stands. It also facilitates increased financial discipline. Because of its increased accuracy, accrual-based accounting is a requirement for audited financial statements. These are statements that are in accordance with Generally Accepted Accounting Principles (GAAP), an industry standard promoted by the American Institute of Certified Public Accountants (AICPA).
Despite these advantages, there are drawbacks to accrual-based accounting. Accrual accounting is considerably more complex than cash basis accounting. In addition, setting up an accrual basis business involves the sometimes burdensome task of identifying and valuing all of the company’s assets and liabilities.
Accrual-based accounting also doesn’t track cash flow very well. It is entirely possible, for example, for an accrual-based income statement to show an impressive profit while cash flow is very poor. Despite this drawback, most large businesses rely on accrual basis accounting because of its increased accuracy.
Changing from a cash to an accrual accounting method isn’t that easy once a business is started. Because Uncle Sam wants to ensure that businesses aren’t trying to obtain unfair tax advantages by making the change, IRS permission may even be necessary before making the switch. An exception to this rule would be if the business involved is fundamentally changing (for example, from a cash basis service business to one that now carries inventory).
Choose Well, Choose Early
Because of the potential complexities involved, it is generally advantageous for business start-ups to utilize the accounting method they anticipate needing in the future, right from the start. In many cases, that would be accrual accounting.