What Are the Benefits of Accrual Basis Accounting?
There are two standard forms of accounting: accrual and cash-basis. Accrual basis is the form accepted by the United States generally accepted accounting principles, also known as GAAP. Accrual basis statements will use terms like accounts receivable, accounts payable and accrued expenses.
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Timing
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The accrual method of accounting closely matches the timing of revenues and expenses. Under this method, accountants recognize revenue when services and goods are provided, not when money exchanges hands. This is a major benefit, giving business owners a realistic picture of how the business is doing financially. For example, suppose a firm has sales of $100,000 in year one. Commission on those sales to the salespeople is $10,000 , but it won't be paid until year two. Under accrual basis accounting the commission expense would still be included in year one to recognize the costs to the company associated with the sales.
Reliability
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Firms using the accrual basis cannot manipulate earnings and expenses. It doesn't matter when cash is received or paid -- income and expenses are recognized when they happen. That makes accrual method more reliable than cash, where you can manipulate when you recognize income and expenses. For example, with cash basis accounting you may choose to pay an expense in year two that was actually incurred at the end of year one, thus manipulating profits in year one to appear higher.
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Clarity
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When accountants use accrual accounting they report both a business's present accounts payable and accounts receivable on the balance sheet. These accounts can be classified as current or long-term, facilitating planning and analysis of a firm's operations. If a business presents $100,000 in current accounts payable and only $100 as cash, managers and investors may wonder how these liabilities will be paid. Financial statements are much more clear under the accrual basis of accounting.
Computerized Accounting
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Accounting systems can be set up to process and report under the accrual basis of accounting. Accountants can set up the system so that whenever an invoice is created, a revenue account is automatically credited, saving lots of time and minimizing errors. When vendors' bills are entered in an accounting program, expenses are debited. You can usually set up your vendors under this system, so that when you make a purchase, certain expense accounts are charged automatically. In both cases, revenue and expenses are recognized when invoices and bills are input, not when they are paid.
Considerations
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Many firms use the cash basis for daily internal reporting then adjust the books at year-end to reflect accrual basis with accounts payable and receivable, accruals and depreciation expense. At month-end accountants often look for bills outstanding and revenues that need to be recognized in that month. Then they adjust the general ledger with journal entries, such as a credit to a liability and a debit to an expense. These adjusting journal entries generally do not affect cash accounts and are reversed in the following period.
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