Advantages & Disadvantages of an Accrual Based Accounting System
Accrual accounting, required under generally accepted accounting principles (GAAP), attempts to mimic the economic reality of a company's business activities instead of recording transactions simply as they occur. For large companies, accrual accounting is a given. However, small companies may not benefit from all that accrual accounting has to offer but may still be saddled by the costs. By understanding some of the advantages and disadvantages of accrual accounting, you can choose the method that is right for your business.
Accrual accounting, by matching revenue and expense, allows for financial statements that are relatively unaffected by the cash timing of transactions. This is an attempt to make periodic financial statements more representative of the health of the business, as opposed to the whims of the checkbook. While GAAP is not required for all small businesses, if your plans include expansion to outside investors, GAAP — and the accrual accounting that comes with it — will probably be in your future.
The matching of revenue and expense under accrual accounting allows for more useful analysis of your own business. For example, let's say you buy an expensive specialized machine for your company that you plan to use over the next 10 years. Under accrual accounting, the cost of the machine will be spread over the period of use. Just as each of the 10 years will have some of the benefit of the machine, through the revenue gained for the sales of the product that the machine produces, each of the years will get some of the expense as well. Under cash basis accounting, in comparison, the entire cost of the machine will be recorded whenever the cash changes hands. This could be before, at the same time or even after the machine is put into production.
If your company has already started business under one method of accounting, it can be difficult to switch. Because many small businesses have cash-flow difficulties at inception, it is common to start a business under the cash basis of accounting out of the company's checkbook. This allows the business owner to tightly watch cash levels. However, as the business expands, this method can be quickly outgrown and, even though accrual accounting may be more appropriate, converting the accounting system can be time-consuming and costly.
A disadvantage of accrual accounting is its difficulty. Rules regarding revenue and expense recognition can be quite complicated, and if your small business wishes to record transactions properly and fully in accordance with GAAP, you may need the help of an accountant. While not GAAP compliant, cash basis is quite simple, and if you don't anticipate expanding your business much in the future, it could be just the right type for your needs.
- Principles of Financial Accounting; Kermit P. Larson, et. al