When considering using accrual basis accounting to record financial transactions, business owners need to remember that no accounting method is perfect. Accrual accounting has both advantages and disadvantages. Advantages include matching revenues with expenses to determine net income. Accrual accounting also has several disadvantages.
Accounting systems build in additional complexities to meet the needs of accrual accounting. The accounting system manages the details of customer account receivables and of vendor payables. Expense transactions, which include a payment for several periods of benefits, such as a 12-month insurance policy, need to be configured to record a portion of that expense each period. Payments received from customers for several periods of service must be recognised initially as a liability. Every period, which is an entry recognising a portion of that payment as revenue, must be made.
Lack of Cash Focus
Accrual accounting focuses on calculating net income and ignores the cash impact of financial transactions. Customers who purchase products or services on credit increase revenue, but not cash. Net income increases, while the cash balance remains the same. Creditors and supplier expect to be paid on time and in cash. A company that concentrates on increasing net income while disregarding cash, may show healthy profits but not have enough cash to meet its financial obligations.
Additional Record Keeping For Taxes
Accrual accounting records cannot be used in filing the business owners' income tax return. Small business owners report their business income by including schedule C with their personal tax returns. Revenues and expenses are reported on schedule C using a cash basis, not the accrual basis. If business owners use accrual accounting to create their financial statements, they cannot use this information on their tax returns. Business owners must keep additional records, including cash receipts, for the revenues and expenses reported on the tax returns.