As an audit supervisor at Dalby, Wendland & Co., I’ve seen several instances in which the importance and usefulness of accrual accounting in monitoring business performance and making business decisions isn’t fully understood.
We’re all familiar with the old saying that hindsight is 20/20. But this saying holds true only when monitoring your business on a cash basis of accounting since those methods generally recognize transactions only when cash is exchanged, which tends to be at the end of the transaction cycle.
Accrual accounting, on the other hand, generally recognizes revenues when earned and expenses when incurred regardless of when the exchange of cash takes place. In other words, revenues and expenses are recorded on or near the inception of the transaction cycle, well in advance of when the related cash transactions take place. This results in the availability of more timely financial information to monitor your business. In addition, the revenues reported are more correlated with the expenses reported.
To illustrate these concepts, suppose Company A makes sales during the month of $100,000, incurs expenses incurred for the month of $120,000, has cash receipts of $130,000 and makes cash disbursements of $70,000. If the owner of Company A monitors performance only on a cash basis, it would appear as if Company A made a net profit of $60,000 ($130,000 cash receipts less $70,000 cash disbursements). If the owner of Company A monitors performance on an accrual basis, however, it’s apparent that regardless of the excess of cash receipts over cash disbursements for the month, Company A actually had a net loss of $20,000 ($100,000 sales made during the month less related expenses incurred of $120,000). As you can see, accrual accounting provides a true picture of company performance, and the owner can make changes more quickly in response.
Another drawback to cash methods of accounting is their lack of consistency. Suppose that during 2011, Company A made no estimated income tax payments and had a large balance of income tax due with their 2011 income tax returns totaling $200,000, which was paid in 2012 with their return. To avoid such a large payment due with their return in the future including, the related penalties for underpayment of estimated tax, Company A decides to make estimated payments during 2012 totaling $200,000. For the 2012 return filed in 2013, Company A has no balance due on their return as a result of making estimated payments in 2012. On the cash basis, Company A would show income tax expense of $0 for 2011 and $400,000 for 2012. On the accrual basis, Company A would show income tax expenses of $200,000 for both 2011 and 2012, which is more consistent between years and a more accurate reflection of expenses incurred each year. If the owner was monitoring financial performance on a cash basis only, she would have gotten the impression net income was $200,000 higher in 2011 than it actually was. This potentially could have negative consequences if business decisions are made based on this misleading information.
In addition, there’s danger in solely relying on cash basis financial statements to forecast future cash flows since most future obligations aren’t reflected. Assume Company A enters into a $500,000 note payable in 2008 with interest only payments due until Jan. 1, 2013, when the entire $500,000 principal balance is due.
On the cash basis of accounting for 2008, Company A would record income related to receipt of the funds from the note payable and would record interest expense related to the interest only payments for 2008 to 2012. In 2013, Company A would record an expense related to the payment of the entire $500,000 principal balance. On the accrual basis, along with the expense recorded for interest payments due, Company A would have recorded a note payable on their balance sheet in 2008 instead of income, which would remain on the balance sheet until 2013 when it was paid. If the owner was monitoring financial performance on a cash basis only, a review of year-end balance sheets for 2008 to 2012 wouldn’t reflect that a $500,000 payment related to the note payable was due in 2013. This poses a risk that future obligations won’t be considered in business decisions and, as a result, cash on hand could be insufficient to pay them.
Since the accrual basis of accounting is widely considered a more accurate representation of the financial position and results of operations of a business, most financial institutions and regulatory agencies require accrual basis financial statements.
As you can see, there are significant risks in only monitoring your business performance based on a cash basis of accounting. While monitoring the cash position of your business is important, implementing accrual basis accounting offers more timely, accurate and consistent information for you to use in making business decisions.