Businesses account for their activities under the cash basis or the accrual basis. Under the cash basis, transactions are recognized and recorded when cash changes hands. Under the accrual basis, transactions are recognized and recorded when they occur, for example, when goods are shipped or when a business debt is incurred.
While the cash basis of accounting is easy to implement, the accrual basis provides a better picture of your company’s finances and its overall financial health.
According to the World Bank, one advantage of accrual accounting is that it provides accountability for the company’s resources and how those resources are used. For example, under accrual accounting, every receivable is recorded on the company’s books from the moment of its inception, representing future streams of income. Under cash basis accounting, only cash payments received are recorded. Therefore, a financial statement user could not clearly determine how much future cash and income will flow into the business.
Other classes of assets, such as plant and equipment, are better managed under accrual accounting. Management can clearly track assets and more easily determine when they have reached the end of their useful lives and need to be replaced.
Liabilities also become more transparent when they are recorded under the accrual basis of accounting. Or, as noted by Ian MacIntosh, Chairman of the Accounting Standards Board, accrual accounting provides financial statement users with a “full appreciation” of a business’s future obligations.
Under cash accounting, liabilities are not recorded; rather, expenses are recognized when they are paid. The full extent of future obligations is not clear under the cash basis. An advantage of the accrual basis of accounting is that financial statement users can clearly identify all obligations of the business and the dates those obligations will come due. This is a powerful tool when projecting future cash flow.
Because of its advantages with regards to assets and liabilities, accrual basis accounting lets management more easily control cash. Management can predict future cash inflows and outflows and identify borrowing needs when cash flow is anticipated to be low or plan for additional income through investing excess cash.
Revenue and Expense Matching
The most fundamental advantage of accrual basis accounting is that it matches revenues to the expenses incurred to generate them, allowing management to monitor its profitability. According to Investopedia, this is particularly important as businesses enter into financial transactions that may not physically materialize until a distant future date. For example, credit transactions to purchase raw materials may repay over years instead of months, and the products created from those materials might generate revenue streams far into the future. Under accrual accounting, both transactions are recorded in the period when they occur and management can clearly determine whether the net effect of production was profitable.