Accrual-based accounting method and its double-entry ledger system

There are two types of accounting methods:” cash-based” and “accrual-based.”

IRS, or industry standards, require the following companies to use accrual-based accounting method:

1. C corporations, partnerships with a C corporation partner, and tax shelters.
2. Companies with average revenue of $25 million or more over three years.
3. Products-based businesses that carry inventory. This is because even if they're small, the cash method doesn't properly account for the cost of goods sold.
4. Companies that offer credit to customers, such as banks and lenders.

In addition, accrual accounting is preferred if your business -

1. Transacts on credits, incurs liabilities and assets such as getting loans from lenders or POs from large buyers.
2. Seeks institutional investors from Angels and accelerators to strategic buyers/VCs.

Why is that? Why do we prefer accrual-based financial statements of the above companies as a more reliable indicator of a company's “economic health”? Why is it not “cash in the bank”?

I asked ChatGPT to explain the difference, and below is her answer:

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Accrual-based accounting and its underlying double-entry ledger system are built on the principle that every transaction has a dual impact and involves two accounts. For every debit entry, there is an equal and opposite credit entry. Double-entry offers a complete view of a business's financial health, as it tracks not only cash but also assets, liabilities, revenues, and expenses. Meanwhile, the single-entry cash-based accounting system only tracks cash income and expenses. It does not track assets or liabilities beyond the cash movements.

On the other hand, the double-entry accrual-based accounting is complex to maintain because:

1. Two Entries per Transaction: In double-entry accounting, each financial transaction affects at least two ledger accounts. For every transaction, one account is debited, and another is credited. This requires a clear understanding of how different types of transactions impact various accounts. For instance, purchasing inventory with cash affects both the inventory account (increase) and the cash account (decrease).
2. Account Balancing: The system is based on the accounting equation:

Assets=Liabilities+Equity

This equation must always balance, meaning the total debits must equal the total credits.

Every transaction must be carefully recorded to maintain this balance, which can be

challenging, especially in complex financial environments with numerous transactions.

1. Chart of Accounts: A comprehensive chart of accounts is needed to categorize the transactions accurately. This chart includes a wide range of accounts for assets, liabilities, equity, revenue, and expenses.
2. Error Detection and Reconciliation: While double-entry accounting helps minimize errors due to its dual-entry nature, detecting where errors occur can be challenging. If accounts do not balance, identifying the incorrect entry among hundreds or thousands of transactions can be time-consuming and requires a detailed audit trail.
3. Regulatory and Reporting Requirements: Double-entry accounting is suited for businesses that must comply with various financial reporting standards such as GAAP (Generally Accepted Accounting Principles) or IFRS (International Financial Reporting Standards). Compliance requires detailed financial records that accurately reflect every aspect of a company’s financial activities, demanding high precision and expertise.
4. Software and Skill Requirements: Efficiently managing a double-entry accounting system typically requires specialized accounting software and skilled personnel. Accountants must understand not only the basic principles of debits and credits but also how transactions impact financial statements and the business's overall financial health.

Accrual accounting offers a comprehensive view of a company's financial health since it records all commitments and expectations, regardless of cash movements. This is essential for stakeholders like investors, creditors, and management, who need detailed and realistic views of business performance. This method also allows for better business planning and financial analysis because it includes receivables, payables, assets, and liabilities. However, the downside of maintaining such a system would be its high cost, which can sometimes be prohibitive for small/startup companies.