Two methods of accounting are common in business: cash basis and accrual. The former requires accountants to record transactions when a transaction involves cash changing hands. The latter does not have this requirement; accountants record transactions as they occur. Accrual accounting allows for an accurate historical presentation of financial transactions.
Companies can typically choose between the cash basis and accrual accounting method. While both are acceptable, larger businesses — those exceeding $5 million in sales annually — should use accrual accounting. Another guideline is companies that have $1 million in annual inventory-based sales. Accountants use these standards as a general cutoff between the two methods. Generally accepted accounting principles recognizes both methods, but prefers accrual accounting.
The accounting cycle is a basic tool that dictates the use of accrual accounting. The cycle includes four steps. These are recording transactions, adjusting accounts, preparing statements and closing temporary accounts. Recording transactions occurs throughout the month, following the guideline for recording transactions as they occur. Adjustments are necessary to correct account balance and prepare the company’s books for closing. Financial statements contain aggregate totals from general ledger accounts, indicating profitability and net worth prior to closing temporary accounts to permanent accounts.
Under accrual accounting, companies typically experience a better historical record for financial performance analysis. Transactions that occur each month have a corresponding date in the general ledger. Owners and managers can review the general ledger and determine when they experienced higher sales or increase business activity. Financial information also mirrors other companies in the business environment. This allows benchmarking, which compares one company’s performance to another’s information.
Companies must follow more rules under accrual accounting than cash basis. Generally accepted accounting principles have several different guidelines that meet the timelines, accuracy and validity of financial information. To complete this process properly, a company will often have to record more journal entries. These entries accrue or defer income or expenses. While presenting a more accurate financial picture, it does take more time to complete and review for accuracy.