The Disadvantages of the Accrual Method in Finance
When a business uses the accrual method in finance, it records and reports revenue as it is earned and not as it is received. The accrual method also reports and records expenses as they incur and not as they are paid. The accrual method produces more accurate financial recording and reporting because it matches income and expenses to specific periods, but it also has its disadvantages.
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Taxes
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Under the accrual method, when a business performs a service or makes a sale on credit for which it has not received payment, it still records the revenue as earned. Doing so can become an issue when the business does not receive the total amount of income it recorded as earned by the end of the tax year. If this occurs, the business ends up paying taxes on income it did not actually receive.
Actual Income and Liabilities
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When using the accrual method, the income recorded in a company’s books is often not the same as the actual cash it has available for use, which can lead to cash flow problems. This issue occurs because the company has not actually received all of the money owed by customers. The same is true for liabilities. When a company records liabilities it has not yet paid, its total liabilities for a period can seem overstated.
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Difficulty
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The accrual method is more difficult to implement and carry out than the cash method because it requires more complex general ledger journal entries. For instance, the accrual method requires companies to first record the income not received and expenses not yet paid. As the income is received and the expenses are paid, the company must make adjusting entries to its general ledger journal entries for each period income is received and expenses are paid out.
Financial Statements
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If the company does not make adjusting entries in its general ledger throughout the year, it leads to problems on its year-end financial statements. Not making the necessary adjusting entries for its liabilities leads to an understatement of total liabilities on its balance sheet. Not making the adjusting entries for its expenses leads to an overstatement of its expenses on the income statement. If the company fails to make the adjusting entries for income during the year, it leads to an overstatement of net income on its year-end income statement.
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