Accrual based accounting is the system of choice adopted by professionally qualified accountants to record the financial transactions of major corporations. It has so many advantages when compared with the alternative, cash based bookkeeping, that it should be favored by businesses of any size. Even if you are just starting out in business, there are lots of good reasons to adopt accrual based accounting.
Compliance with recognized accounting standards
In the USA most companies, governments and non-profit organizations use US Generally Accepted Accounting Principles (GAAP) which are established by the Financial Accounting Standards Board. Two of the major principles are revenue recognition and matching of expenses and revenue. These two principles are the cornerstones of accrual based accounting, ensuring that revenue is recorded when earned rather than when the cash is received, and that all of the expenses required to earn that revenue are brought to account in the same financial period as the revenue itself.
Conformity with requirements of taxation regulations
In the United States, and many other countries as well, there is a divergence between the financial results companies report internally and the calculation methods required to establish annual tax liabilities. This arises because of timing differences, particularly in areas such as depreciation of assets and provisions for potential bad debts or warranty liabilities. Put simply, this means that although the organization may use provisions to spread a potential financial burden over a number of fiscal years, the cost is not allowable as a deduction against income until the loss or charge actually occurs. This may sound like a good reason for returning to cash based accounting, but in practice it would be nothing short of a nightmare to attempt to prepare a corporate tax return without an accrual based accounting report as a starting point.
The US Securities Exchange Act of 1934 requires periodic reporting of information by companies with publicly traded securities. More recently the Sarbanes-Oxley Act of 2002 has provided for enhanced financial disclosures by companies as well as greater oversight of the auditing profession. In order to comply with the requirements of this legislation, large corporations need to observe the accounting standards detailed in GAAP above, and therefore must adopt accrual based accounting.
Production of accurate financial statements
The fact that GAAP requires an accrual based accounting system underlines its status as the accepted method of producing an accurate balance sheet and profit and loss statement. A simple cash accounting system fails to recognize revenue and expense in the appropriate fiscal period, leading to major fluctuations between one period and the next. Bankruptcy could be imminent, but a cash accounting system would not necessarily disclose this important fact.
Standardization and simplification of accounts department operation
An accrual based accounting system makes the preparation of monthly, quarterly, half-yearly and yearly financial reports much easier. Standard expenses which may only be paid annually, or at even greater intervals, can be recognized, and the accrual or prepayment incorporated into monthly automated journal entries. These automated entries can also deal with provisions for items such as warranty or bad debts, and with write-down of assets by means of monthly depreciation. Thus the more tedious parts of an accountant’s work can be automated, also ensuring that no regular expenses are overlooked or forgotten.
Professionally qualified accountants the world over have been taught the principles of accrual based accounting, which they put into practice every day in their role as guardians of the assets and recorders and reporters of the financial transactions of corporations. No self-respecting competent accountant would dream of using any system other than accrual based accounting, with its advantages of compliance with accounting standards and corporations and taxation law, its accuracy and its ease of operation.